The International Monetary Fund (IMF) has warned about the side effects of sharp monetary tightening in its recent global economic outlook. The economic counselor and Director of Research of IMF, Pierre-Olivier Gourinchas, noted that the economic slowdown is most pronounced in advanced economies and inflation is falling more slowly than anticipated. He stressed that financial risks have increased, and although activity shows signs of resilience, the situation remains fragile. While unemployment remains low, monetary policy may need to tighten further or stay tighter for longer than currently anticipated.
Gourinchas stated that he is unconvinced about the risk of an uncontrolled wage-price spiral, but more worrisome are the side effects that the sharp monetary policy tightening of the last year is starting to have on the financial sector. He explained that the financial sector had become too complacent about maturity and liquidity mismatches due to a prolonged period of low-interest rates and muted inflation. However, the tightening of monetary policy caused losses on long-term fixed-income assets and raised funding costs.
According to Gourinchas, inflation is much stickier than anticipated. Core inflation, which excludes energy and food, has not yet peaked in many countries. Although labor markets remain very strong in most advanced economies, downside risks dominate, and the fog around the world economic outlook has thickened. We are, therefore, entering a tricky phase during which economic growth remains lackluster by historical standards, financial risks have risen, yet inflation has not yet decisively turned the corner.
The IMF economist believes that once again, banks have been reminded of the fragile nature of the economic situation given the recent banking instability. With the risks to the financial sector’s stability increasing, the need for undertaking reforms that reduce system-wide risks and preserve financial stability becomes both more urgent and more compelling. Governments and regulators need to act sooner rather than later to increase regulatory and supervisory vigilance, address the rapidly evolving challenges, and safeguard financial stability.
The challenges of monetary tightening and financial risk are not limited to developed countries alone. Emerging market economies have seen increased interest rate differentials and tighter financial conditions, while the US dollar has further strengthened. Commodity exporters have experienced pressures on their exchange rates, international reserves, and external balances, and even countries without significant foreign exchange exposures or balance sheet mismatches cannot afford to be complacent about financial stability risks.
While everyone understands that monetary tightening is necessary, the risks from financial instability cannot be ignored. Policymakers need to weigh the benefits of further monetary tightening against the risks of a sudden increase in market volatility, sharp asset price corrections, and a rise in debt servicing costs, which could trigger widespread debt defaults or bank failures. In the near term, policymakers need to focus on ensuring that financial markets remain resilient and orderly, while the necessary reforms for safeguarding financial stability need to start soon.
In conclusion, the IMF economist warns that the global economy is in a tricky phase with financial risks rising, economic growth being lackluster by historical standards, and yet inflation has not decisively turned the corner. Policymakers must remain vigilant and prepared to act quickly and decisively to preserve financial stability and, on a broader level, the stability of the global economy.