(Credit: IMF Photo/Yam-G-Jun) By Tobias Adrian, Sheheryar Malik, and Jason Wu When it comes to financial stability, the world is facing a split screen of short-term and medium-term factors. The good news is that near-term financial stability risks remain contained. Why? Because the likelihood of a soft landing for the global economy has significantly increased. As inflation continues to decline, major central banks have started cutting interest rates. This is boosting already buoyant asset prices and keeping financial market volatility subdued. At the same time, our latest Global Financial Stability Report calls on policymakers to remain vigilant about the medium-term prospects. We want to highlight two areas of concern. Concerns down the road For one, accommodative financial conditions have continued to increase vulnerabilities, such as lofty asset valuations around the world, increased government and private-sector debt levels, and more use of leverage by financial institutions, to name a few. All this could amplify future shocks to financial systems. We have seen vulnerabilities mount before, most notably ahead of the 2008 global financial crisis. The build-up is usually gradual, which should give policymakers time to adjust. The second area of concern is the disconnect between heightened uncertainty—especially related to increased geopolitical risks—and financial market volatility. A standardized measure of volatility has drifted far below geopolitical risk measures. This indicates that asset prices may not fully reflect the potential impact of wars and trade disputes. Such a disconnect makes shocks more likely, because high geopolitical tension could trigger sudden sell-offs in financial markets and prompt volatility to snap back as it catches up to uncertainty. In that case, some financial institutions may be forced to sell assets or deleverage balance sheets to meet margin calls or satisfy risk limits. While such actions may protect individual institutions, they can actually exacerbate market sell-offs.  The market turmoil in early August, while not a geopolitical event, still provides a glimpse into such a scenario. The narrowing of US-Japan interest rate differentials following a rate hike by Bank of Japan in late July and a soft US payrolls report in early August led to a strengthening of the yen-dollar exchange rate. This, in turn, precipitated the unwinding of leveraged yen carry trades and spurred sell-offs in stock markets. While US stock indexes declined significantly, Japan’s benchmark Nikkei index dropped by 12 percent, its largest single-day move since 1987. Other factors also exacerbated the sell-off: investors started to buy equity put options to protect against losses, driving up stock volatility especially in Japan and the United States. Meanwhile, the volatility spikes triggered risk limits for some investors like hedge funds and momentum traders, leading to further sell-offs. To be sure, market pressures proved to be temporary and did not threaten financial stability. But the sharp move by investors toward risk avoidance clearly showed how shifting sentiments can quickly amplify volatility.  Another key variable for financial policymakers is the economic outlook. The IMF’s Growth-at-Risk framework links current financial conditions to the distribution of possible outcomes for future growth and sums up our current financial stability assessment. Near-term risks to growth appear contained at moderate levels: the probability of global growth falling below the World Economic Outlook baseline for 2025 is estimated to be around 58 percent. And tail outcomes are not too severe owing to financial conditions having remained accommodative alongside healthy credit growth. And yet, policymakers need to be vigilant. Given the large disconnect between uncertainty, geopolitical risk, and financial market volatility, surges in volatility would likely be more prevalent. In a scenario where financial conditions tighten akin to what we saw on August 5—and remain at that level for an entire quarter—the probability of 2025 growth falling below the WEO baseline increases to around 75 percent, comparable to the peak of the COVID crisis, suggesting that downside risks could rise materially when volatility catches up to uncertainty.  Time to act In short, as the global economy continues to grow, and with monetary policy easing, risk-taking by investors could increase. And thus, vulnerabilities such as debt and leverage could build up, raising downside risks in the future. So, what can policymakers do now? In countries where inflation remains stubbornly above targets, central banks should push back against overly optimistic investor expectations for monetary policy easing. Where inflation is very close, or at target, policymakers should show openness to easing faster, if evidence suggests inflation may end up undershooting the target for a while. On the fiscal side, adjustments should focus primarily on credibly rebuilding buffers to keep financing costs at reasonable levels, as shown in the IMF’s latest Fiscal Monitor. We also need more progress on financial policies. Fragilities created by nonbanks using more leverage and maturity mismatches underscore the need for more active regulatory and supervisory engagement. This includes implementing the Financial Stability Board’s agreed-upon standards, the strengthening of macroprudential policy frameworks to contain excessive risk taking, and the additional collection of data to enhance transparency for market participants and policy makers alike. Furthermore, it should be ensured that central counterparties—increasingly used to clear financial transactions— remain resilient; for instance, by having sufficient liquidity to cover potential losses that may arise during periods of market stress. Now is the time for policymakers to keep a close eye on the second screen: while achieving an economic soft landing remains critical, we need to step up proactive measures to prevent future fragilities. —This blog is based on Chapter 1 of the October 2024 Global Financial Stability Report. For more, see the accompanying blog posts on the report’s analytical chapters: How High Economic Uncertainty May Threaten Global Financial Stability and Artificial Intelligence Can Make Markets More Efficient—and More Volatile.
(Credit: IMF Photo/Monacoshots) By Pierre-Olivier Gourinchas Let’s start with the good news: it looks like the global battle against inflation has largely been won, even if price pressures persist in some countries. After peaking at 9.4 percent year-on-year in the third quarter of 2022, we now project headline inflation will fall to 3.5 percent by the end of next year, slightly below the average during the two decades before the pandemic. In most countries, inflation is now hovering close to central bank targets, paving the way for monetary easing across major central banks. The global economy remained unusually resilient throughout the disinflationary process. Growth is projected to hold steady at 3.2 percent in 2024 and 2025, but some low-income and developing economies have seen sizable downside growth revisions, often tied to intensifying conflicts. 
In advanced economies, growth in the United States is strong, at 2.8 percent this year, but will revert toward its potential in 2025. For advanced European economies, a modest growth rebound is expected next year, with output approaching potential. The growth outlook is very stable in emerging markets and developing economies, around 4.2 percent this year and next, with continued robust performance from emerging Asia. 
The decline in inflation without a global recession is a major achievement. As Chapter 2 of our report argues, the surge and subsequent decline in inflation reflects a unique combination of shocks: broad supply disruptions coupled with strong demand pressures in the wake of the pandemic, followed by sharp spikes in commodity prices caused by the war in Ukraine. These shocks led to an upward shift and a steepening of the relationship between activity and inflation, the Phillips curve. As supply disruptions eased and tight monetary policy started to constrain demand, normalization in labor markets allowed inflation to decline rapidly without a major slowdown in activity. Clearly, much of the disinflation can be attributed to the unwinding of the shocks themselves, together with improvements in labor supply, often linked to increased immigration. But monetary policy played a decisive role by keeping inflation expectations anchored, avoiding deleterious wage-price spirals, and a repeat of the disastrous inflation experience of the 1970s. Despite the good news on inflation, downside risks are increasing and now dominate the outlook. An escalation in regional conflicts, especially in the Middle East, could pose serious risks for commodity markets. Shifts toward undesirable trade and industrial policies can significantly lower output relative to our baseline forecast. Monetary policy could remain too tight for too long, and global financial conditions could tighten abruptly. 
The return of inflation near central bank targets paves the way for a policy triple pivot. This would provide much-needed macroeconomic breathing room, at a time where risks and challenges remain elevated. The first pivot—on monetary policy—is under way already. Since June, major central banks in advanced economies have started to cut policy rates, moving toward a neutral stance. This will support activity at a time when many advanced economies’ labor markets are showing signs of cooling, with rising unemployment rates. So far, however, the rise in unemployment has been gradual and does not point to an imminent slowdown. 
Lower interest rates in major economies will ease the pressure on emerging market economies, with their currencies strengthening against the US dollar and financial conditions improving. This will help reduce imported inflation, allowing these countries to pursue their own disinflation path more easily. However, vigilance remains key. Inflation in services remains too elevated, almost double pre-pandemic levels. A few emerging market economies are facing a resurgence of inflationary pressures and have started to raise policy rates again. Furthermore, we have now entered a world dominated by supply disruptions—from climate, health, and geopolitical tensions. It is always harder for monetary policy to contain inflation when faced with such shocks, which simultaneously increase prices and reduce output. Finally, while inflation expectations remained well-anchored this time, it may be harder next time, as workers and firms will be more vigilant about protecting pay and profits. The second pivot is on fiscal policy. Fiscal space is a cornerstone of macroeconomic and financial stability. After years of loose fiscal policy in many countries, it is now time to stabilize debt dynamics and rebuild much-needed fiscal buffers. While the decline in policy rates provides some fiscal relief by lowering funding costs, this will not be sufficient, especially as long-term real interest rates remain far above pre-pandemic levels. In many countries, primary balances (the difference between fiscal revenues and public spending net of debt service) need to improve. For some, including the United States and China, current fiscal plans do not stabilize debt dynamics. In many others, while early fiscal plans showed promise after the pandemic and cost-of-living crises, there are increasing signs of slippage. The path is narrow: delaying consolidation increases the risk of disorderly market-imposed adjustments, while an excessively abrupt turn toward fiscal tightening could be self-defeating and hurt economic activity. 
Success requires implementing a sustained and credible multi-year adjustments without delay, where consolidation is necessary. The more credible and disciplined the fiscal adjustment, the more monetary policy can play a supporting role by easing policy rates while keeping inflation in check. But the willingness or ability to deliver disciplined and credible fiscal adjustments have been lacking. The third pivot—and the hardest—is toward growth-enhancing reforms. Much more needs to be done to improve growth prospects and lift productivity, as this is the only way we can address the many challenges we face: rebuilding fiscal buffers; coping with aging and shrinking populations in many parts of the world; tackling the climate transition; increasing resilience, and improving the lives of the most vulnerable, within and across countries. Unfortunately, growth prospects for five years from now remain lackluster, at 3.1 percent, the lowest in decades. While much of this reflects China’s weaker outlook, medium-term prospects in other regions, including Latin America and the European Union, have also deteriorated. Faced with increased external competition and structural weaknesses in manufacturing and productivity, many countries are implementing industrial and trade policy measures to protect domestic workers and industries. But external imbalances often reflect macroeconomic forces: a weakening domestic demand in China, or excessive demand in the United States. Addressing these will require setting the macro dials appropriately. Moreover, while industrial and trade policy measures can sometimes boost investment and activity in the short run—especially when relying on debt-financed subsidies—they often lead to retaliation and fail to deliver sustained improvements in standards of living. They should be avoided when not carefully addressing well-identified market failures or narrowly defined national security concerns. Economic growth must come instead from ambitious domestic reforms that boost technology and innovation, improve competition and resource allocation, further economic integration and stimulate productive private investment. Yet while reforms are as urgent as ever, they often face significant social resistance. How can policymakers win the support they need for reforms to succeed? As Chapter 3 of our report shows, information strategies can help but can only go so far. Building trust between government and citizens—a two-way process throughout the policy design—and the inclusion of proper compensation to offset potential harms, are essential features. Building trust is an important lesson that should also resonate when thinking about ways to further improve international cooperation and bolster our multilateral efforts to address common challenges, in the year that we celebrate the 80th anniversary of the Bretton Woods institutions. —This blog is based on the October 2024 World Economic Outlook. For more, see blog posts on the report’s analytical chapters: Global Inflationary Episode Offers Lessons for Monetary Policy and Support for Economic Reforms Hinges on Communication, Engagement, and Trust. 
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