Inflation Remains Risk Confronting Financial Markets
IMF Blog, July 27, 2023
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- Authors: Tobias Adrian, Fabio Natalucci, Jason Wu
- Published: July 27, 2023
Overview
- Publication: blog piece by Tobias Adrian, Fabio Natalucci, Jason Wu, July 27, 2023.
- Central message: Despite recent moderation in headline inflation, sticky core and services inflation plus investor expectations of a rapid disinflation create risks that central banks may need to keep interest rates higher for longer than currently priced, amplifying financial stability and growth risks.
Current inflation and market pricing
- Year-on-year headline inflation:
- United States: around 3 percent.
- Euro area: below 5.5 percent.
- Core inflation (excluding food and energy) has declined more slowly; services inflation is particularly sticky.
- Market-implied expectations:
- Europe: inflation options show investors assign roughly similar odds to inflation returning to the European Central Bank’s 2 percent target and inflation remaining around 4 percent.
- United States: investors appear to put high odds on inflation being above target at around 3 percent.
- Central narrative among market participants: benign soft landing with inflation returning to target relatively quickly and only a modest slowdown in economic growth.
Financial conditions and monetary transmission
- Financial conditions (index summarizing financing costs in housing, credit, and equity markets) have eased notably in the United States and euro area in recent quarters.
- This easing has occurred despite continued monetary policy tightening by the Federal Reserve and ECB, reflecting investors’ relatively benign outlook for price pressures and boosted market valuations.
- Historical transmission: tighter monetary policy normally tightens financial conditions and slows aggregate demand; recent easing may complicate achieving 2 percent inflation targets.
- Complicating factors:
- Prolonged period of extremely loose financial conditions followed by a tightening cycle that began when inflation was already elevated may have dulled transmission.
- High share of fixed-rate mortgages with low rates in the United States due to past refinancings.
- Corporations extended debt maturities taking advantage of low borrowing costs.
- Structural changes in labor and housing markets after the pandemic may play a role.
- Monetary policy operates with considerable lags; pace and timing of transmission remain uncertain.
Credit markets, banks, and nonbank lending
- Bank credit growth:
- Remained positive in both the United States and euro area, but the pace has slowed markedly, especially in the euro area.
- Loan officer surveys point to significantly slower demand for credit and tightening underwriting standards by banks, suggesting further deceleration in bank credit provision may be forthcoming.
- Large bank earnings:
- Recent reports show strength at large banks, boosted by higher interest rates charged on loans while remuneration on deposits lags policy tightening.
- Lending survey results suggest profitability could moderate going forward.
- Nonbank credit provision:
- Corporate bond issuance down significantly this year.
- Pronounced differentiation: high credit–rating issuers can still borrow relatively easily; lower-rated counterparts face greater headwinds.
- Default rates are starting to increase among lower-rated borrowers (albeit from low levels), along with bankruptcies at small and medium-sized enterprises—indicative of a deteriorating credit cycle.
Risk scenarios and potential vulnerabilities
- Scenario: underlying inflation remains sticky and declines only slowly.
- Consequence: tighter monetary policy for longer than markets currently price, resulting in higher real interest rates.
- Market impact: hurt investor sentiment, repricing of risk assets (equities and credit), tightening of financial conditions.
- Macro risk: heightened risks to economic activity and financial stability.
- Financial stability vulnerabilities:
- Strategies predicated on fast disinflation and a soft landing are vulnerable to abrupt tightening in financial conditions and unwinding of highly leveraged investment strategies, potentially leading to disorderly markets.
- Example practice: investors financing purchases of Treasury securities while selling futures to capture price differences; a sudden shock (e.g., upside inflation surprise) could widen price differences, force leveraged unwinds, and cause selling into falling prices.
- Potential adverse feedback loop if banks lack capacity or willingness to buy stressed securities—reminiscent of Treasury market stress in March 2020.
- US banking sector: some regional lenders may face continued profitability issues; the March banking turmoil in the United States and the government-supported sale of Credit Suisse highlighted managerial and supervisory failures and the amplification of investor runs by technology and social media.
- Market positioning and pricing suggest investors may be too optimistic about speed of disinflation and soft landing prospects; core inflation remains sticky and the risk of resurgence is not fully tamed.
Policy implications and recommendations
- Central banks should remain determined in their fight against inflation until tangible evidence shows inflation is sustainably moving toward targets.
- Policymakers should recognize the uncertain and potentially delayed transmission of monetary tightening and the uneven impact across borrowers (mortgage holders, corporations, lower-rated issuers, SMEs).
- Financial supervisors and market participants should monitor:
- Leverage and positioning in Treasury and other bond markets.
- Differentiation in credit access across rating categories.
- Bank profitability dynamics, underwriting standards, and signs of deteriorating credit quality among SMEs and lower-rated borrowers.
- Prepare for scenarios requiring prolonged higher real interest rates and associated tightening of financial conditions to avoid being caught off guard by abrupt repricing events.
Source: IMF blog post by Tobias Adrian, Fabio Natalucci, Jason Wu, July 27, 2023.