How Policy Makers Can Better Predict a Downturn – and Prepare

IMF Blog, October 3, 2017

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The global financial crisis of 2008-2009 illustrated how periods of robust growth and calm financial markets can be followed by sudden market volatility and an unexpected economic downdraft.
Financial conditions—including bond yields, oil prices, foreign exchange rates, and levels of domestic debt—provide valuable clues to the economic outlook and can improve the accuracy of forecasts.
New analysis in the Global Financial Stability Report develops a tool that uses information in financial conditions to quantify risks to future growth and help policy makers take preventive steps.

The tool identifies conditions that often precede trouble within 12 months:
- rising market volatility
- more risk-aversion among investors
- widening of credit spreads (the difference in yield between ultra-safe securities such as US Treasury notes and other forms of debt)
Over a period of two to three years, elevated levels of debt and credit growth are better signals of a challenging outlook.

Low interest rates and rising asset prices can encourage risky behavior by firms and households.
Consequences described:
- increased borrowing and lending fueled by easier underwriting standards
- boosted collateral values, bank capital, and profits
- eventual market recognition of built-up vulnerabilities can trigger rapid increases in funding costs, tightening of credit, cascades of defaults, and bank failures
Historical reference: the crisis culminated in the most severe recession since the 1930s.

The importance of any given gauge depends on the type of economy.
Examples:
- Rising commodity prices benefit exporters such as Australia, Canada, and Brazil.
- Rising commodity prices increase the risk of a downturn in commodity-importing countries.

Credit spreads are low and market volatility is low, suggesting a relatively benign near-term outlook.
Growing debt levels signal risks down the road.
A rapid increase in credit spreads and greater market volatility could significantly worsen the outlook for global growth.

Use macroprudential measures to curb credit growth and reduce the risk of a slump, including:
- requiring banks to hold more capital as a buffer against losses
- requiring families to make bigger down-payments on the homes they buy
Once a crisis appears imminent, policy options include:
- cutting central bank policy rates
- deploying measures used during the last crisis, such as asset-purchase programs and emergency liquidity facilities

Claudio Raddatz Kiefer, Jay Surti — October 3, 2017. How Policy Makers Can Better Predict a Downturn – and Prepare.

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