Global Financial Fragilities Mount Despite Rate Cuts and Buoyant Markets
IMF Blog, October 22, 2024
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Bibliographic details
- Authors: Tobias Adrian, Sheheryar Malik, Jason Wu
- Published: October 22, 2024
Overview
- Publication date and authors: Tobias Adrian, Sheheryar Malik, Jason Wu; October 22, 2024.
- Near-term financial stability risks are described as contained because:
- The likelihood of a soft landing for the global economy has significantly increased.
- Inflation is continuing to decline and major central banks have started cutting interest rates.
- Asset prices are buoyant and financial market volatility remains subdued.
Concerns Down the Road — rising vulnerabilities
- Accommodative financial conditions have continued to increase vulnerabilities, including:
- lofty asset valuations around the world;
- increased government and private-sector debt levels;
- more use of leverage by financial institutions.
- The build-up of vulnerabilities is gradual, which should give policymakers time to adjust.
- Disconnect between uncertainty and market volatility:
- A standardized measure of volatility has drifted far below geopolitical risk measures, indicating asset prices may not fully reflect potential impacts of wars and trade disputes.
- Such a disconnect raises the risk that high geopolitical tension could trigger sudden sell-offs and a sharp reversal in volatility, which could force some financial institutions to sell assets or deleverage, amplifying market stress.
- Market example: early August market turmoil
- Narrowing of US-Japan interest rate differentials after a Bank of Japan rate hike in late July and a soft US payrolls report in early August strengthened the yen-dollar exchange rate.
- The unwinding of leveraged yen carry trades precipitated sell-offs in stock markets.
- Japan’s benchmark Nikkei index dropped by 12 percent, its largest single-day move since 1987.
- Investors buying equity put options drove up stock volatility especially in Japan and the United States, triggering risk limits for some investors (e.g., hedge funds and momentum traders) and prompting further sell-offs.
- Market pressures proved temporary and did not threaten financial stability, but highlighted how shifting sentiments can quickly amplify volatility.
Growth-at-Risk, scenarios, and implications
- IMF’s Growth-at-Risk framework links current financial conditions to the distribution of possible outcomes for future growth and underpins the assessment of financial stability.
- Current near-term assessment:
- The probability of global growth falling below the World Economic Outlook baseline for 2025 is estimated to be around 58 percent.
- Tail outcomes are described as not too severe because financial conditions have remained accommodative alongside healthy credit growth.
- Stress scenario:
- 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.
- This suggests downside risks could rise materially when volatility catches up to uncertainty.
Time to act — policy recommendations
- Monetary policy:
- 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.
- Fiscal policy:
- Adjustments should focus primarily on credibly rebuilding buffers to keep financing costs at reasonable levels, as shown in the IMF’s latest Fiscal Monitor.
- Financial regulation and supervision:
- Address fragilities from nonbanks using more leverage and facing maturity mismatches through more active regulatory and supervisory engagement.
- Implement the Financial Stability Board’s agreed-upon standards.
- Strengthen macroprudential policy frameworks to contain excessive risk taking.
- Collect additional data to enhance transparency for market participants and policy makers.
- Ensure central counterparties remain resilient, for instance by having sufficient liquidity to cover potential losses during periods of market stress.
- Overarching message:
- While achieving an economic soft landing remains critical, policymakers should step up proactive measures to prevent future fragilities as investor risk-taking could increase with monetary policy easing.
—This blog is based on Chapter 1 of the October 2024 Global Financial Stability Report.