Uncertainty Grips Markets as Optimism Wanes
IMF Blog, October 12, 2021
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- Authors: Tobias Adrian
- Published: October 12, 2021
Overview
- Market sentiment has deteriorated since earlier this year amid still elevated financial vulnerabilities and mounting concerns about risks to inflation.
- The world’s central banks, finance ministries, and international financial institutions have asserted—for a year and a half—policy support for economic growth and now must craft strategies that safely approach the next stage of monetary and fiscal policy action.
- The persistent pandemic-stricken atmosphere intensifies uncertainty through the “three Cs”: COVID-19, crypto, and climate change, as discussed in the latest Global Financial Stability Report.
Fading optimism and market developments
- Massive monetary and fiscal policy support in 2020 and 2021 helped limit the economic contraction and supported a strong economic rebound for much of this year.
- The sense of optimism that had propelled markets in the first half of the year is at risk of fading.
- Investors have grown increasingly worried about the economic outlook because of:
- Uneven vaccine access and mutations of the COVID-19 virus leading to a resurgence of infections and more divergent economic prospects across countries.
- Inflation readings above expectations in many countries.
- New uncertainties in some major economies triggered by financial vulnerabilities, surging commodity prices, and policy uncertainty.
- Market movements noted:
- A deterioration in market sentiment since the April 2021 Global Financial Stability Report resulted in a significant decline in global long-term nominal yields in the summer, driven by falling real rates.
- In late September, investor anxiety about inflationary pressures pushed yields higher, entirely reversing the earlier declines.
Financial vulnerabilities and risk channels
- Financial vulnerabilities continue to be elevated in several sectors, partly masked by massive policy stimulus.
- Warning signs include:
- Increased financial risk-taking.
- Rising fragilities in the nonbank financial institutions sector.
- Crypto asset markets:
- Are growing rapidly and crypto asset prices remain highly volatile.
- Financial stability risks are not yet systemic in the crypto ecosystem, but risks should be closely monitored given global monetary implications and inadequate operational and regulatory frameworks in most jurisdictions—especially in emerging market and developing economies.
- Climate-related finance:
- Assets under management in climate-themed investment funds remain relatively small, but inflows have surged.
- There is a promise of cheaper funding costs for climate-friendly firms and greater climate stewardship by funds.
- Scenario risk:
- If investors abruptly reassess the economic and policy outlook, financial markets could endure a sudden repricing of risk that, if sustained, could interact with underlying vulnerabilities and lead to a tightening of financial conditions, putting economic growth at risk.
Policy implications and recommendations
- Policymakers face a challenging trade-off: continue providing near-term support to the global economy while avoiding the buildup of medium-term financial-stability risks.
- Recommended policy approaches:
- Monetary and fiscal policy support should be more targeted and tailored to country-specific circumstances, given the varying pace of the recovery across countries.
- Central banks should provide clear guidance about their future approach to monetary policy to avoid an unwarranted or abrupt tightening of financial conditions.
- Monetary authorities should remain vigilant and, if price pressures turn out to be more persistent than anticipated, act decisively to avoid an unmooring of inflation expectations.
- Fiscal support can appropriately shift toward more targeted measures and be tailored to country-specific characteristics.
- Policymakers should take early action and tighten selected macroprudential tools to target pockets of elevated vulnerabilities.
- Tightening macroprudential tools is critical to address potential unintended consequences of unprecedented policy measures, given the possible need for prolonged policy support.
- Policy priorities for emerging and frontier markets:
- Where possible, begin to rebuild fiscal buffers and implement structural reforms.
- Rebuilding buffers and implementing enduring reforms to boost economic growth prospects will be pivotal to protect against the risk of capital-flow reversals and an abrupt increase in financing costs.
- In a context of higher price pressures, investors are now pricing in a rapid and fairly sharp tightening cycle for many emerging markets, although the increase in inflation is expected to be temporary.
Source: Tobias Adrian, October 12, 2021 — "Uncertainty Grips Markets as Optimism Wanes."