Financial stability risks remain elevated, says IMF

Financial stability risks remain elevated as investors reassess their inflation and monetary policy outlook, the International Monetary Fund (IMF) said Tuesday.

Global financial conditions have eased somewhat since the October 2022 Global Financial Stability Report, driven largely by changing market expectations regarding the interest rate cycle, the IMF pointed out.

while the expected peak in policy rates—the terminal rate—has risen, markets now also expect the subsequent fall in rates will be significantly faster, and further, than what was forecast in October.

As a result, global bond yields have recently declined, corporate spreads have tightened, and equity markets have rebounded.

That said, central banks are likely to continue to tighten monetary policy to fight inflation, and concerns that this restrictive stance could tip the economy into a recession have increased in major advanced economies, the Washington-based financial institution stressed.

Slowing aggregate demand and weaker-than-expected inflation prints in some major advanced economies have prompted investors’ anticipation of a further reduction in the pace of future policy rate hikes.

corporate earnings forecasts have been cut due to headwinds from slowing demand, and margins have contracted across most regions. In addition, survey-based probabilities of recession have been increasing, particularly in the United States and Europe.

However, upside risks to the inflation outlook remain. Despite the recent moderation in headline inflation, core inflation remains stubbornly high across most regions, labor markets are still tight, energy prices remain pressured by Russia’s ongoing war in Ukraine, and supply chain disruptions may reappear, the IMF said.

To keep these risks in check, financial conditions will likely need to tighten further.

If not, central banks may need to increase policy rates even more in order to achieve their inflation objectives.

Given the tension between rising recession risks and monetary policy uncertainty, markets have seen significant volatility.

While many central banks in advanced economies have stepped down the size of hikes, they have also explicitly stated they will need to keep rates higher, for a longer period of time, to tamp down inflation.

Risk assets could face significant declines if earnings retrench further or if investors reassess their outlook for monetary policy given central bank communications.

Globally, the partial reversal of the dollar rally has contributed to recent easing due to improved risk appetite, and some emerging market central banks have paused tightening amid tentative signs that inflation may have peaked.

According to the IMF, financial market volatility is expected to remain elevated and could be exacerbated by poor market liquidity.

For some asset classes (such as US Treasuries), liquidity has deteriorated to the March 2020 lows of the COVID-19 pandemic.

With the process of central bank balance sheet reduction (quantitative tightening) underway, market liquidity is expected to remain challenging.