{
  "title": "Inflation Remains Risk Confronting Financial Markets",
  "publication": "IMF Blog, July 27, 2023",
  "sourceUrl": "https://www.imf.org/en/blogs/articles/2023/07/27/inflation-remains-risk-confronting-financial-markets",
  "canonical": "https://www.imf.org/en/blogs/articles/2023/07/27/inflation-remains-risk-confronting-financial-markets",
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  "summary": "Central banks may keep interest rates higher for longer than currently priced; given investors’ benign inflation outlook and growing expectations for a soft landing, this could increase financial stability risks and weigh on growth.",
  "sections": [
    {
      "heading": "Overview",
      "content": "- Publication: blog piece by Tobias Adrian, Fabio Natalucci, Jason Wu, July 27, 2023.\n- 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."
    },
    {
      "heading": "Current inflation and market pricing",
      "content": "- Year-on-year headline inflation:\n  - United States: around 3 percent.\n  - Euro area: below 5.5 percent.\n- Core inflation (excluding food and energy) has declined more slowly; services inflation is particularly sticky.\n- Market-implied expectations:\n  - 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.\n  - United States: investors appear to put high odds on inflation being above target at around 3 percent.\n- Central narrative among market participants: benign soft landing with inflation returning to target relatively quickly and only a modest slowdown in economic growth."
    },
    {
      "heading": "Financial conditions and monetary transmission",
      "content": "- 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.\n- 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.\n- Historical transmission: tighter monetary policy normally tightens financial conditions and slows aggregate demand; recent easing may complicate achieving 2 percent inflation targets.\n- Complicating factors:\n  - Prolonged period of extremely loose financial conditions followed by a tightening cycle that began when inflation was already elevated may have dulled transmission.\n  - High share of fixed-rate mortgages with low rates in the United States due to past refinancings.\n  - Corporations extended debt maturities taking advantage of low borrowing costs.\n  - Structural changes in labor and housing markets after the pandemic may play a role.\n- Monetary policy operates with considerable lags; pace and timing of transmission remain uncertain."
    },
    {
      "heading": "Credit markets, banks, and nonbank lending",
      "content": "- Bank credit growth:\n  - Remained positive in both the United States and euro area, but the pace has slowed markedly, especially in the euro area.\n  - 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.\n- Large bank earnings:\n  - Recent reports show strength at large banks, boosted by higher interest rates charged on loans while remuneration on deposits lags policy tightening.\n  - Lending survey results suggest profitability could moderate going forward.\n- Nonbank credit provision:\n  - Corporate bond issuance down significantly this year.\n  - Pronounced differentiation: high credit–rating issuers can still borrow relatively easily; lower-rated counterparts face greater headwinds.\n  - 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."
    },
    {
      "heading": "Risk scenarios and potential vulnerabilities",
      "content": "- Scenario: underlying inflation remains sticky and declines only slowly.\n  - Consequence: tighter monetary policy for longer than markets currently price, resulting in higher real interest rates.\n  - Market impact: hurt investor sentiment, repricing of risk assets (equities and credit), tightening of financial conditions.\n  - Macro risk: heightened risks to economic activity and financial stability.\n- Financial stability vulnerabilities:\n  - 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.\n  - 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.\n  - Potential adverse feedback loop if banks lack capacity or willingness to buy stressed securities—reminiscent of Treasury market stress in March 2020.\n  - 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.\n- 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."
    },
    {
      "heading": "Policy implications and recommendations",
      "content": "- Central banks should remain determined in their fight against inflation until tangible evidence shows inflation is sustainably moving toward targets.\n- 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).\n- Financial supervisors and market participants should monitor:\n  - Leverage and positioning in Treasury and other bond markets.\n  - Differentiation in credit access across rating categories.\n  - Bank profitability dynamics, underwriting standards, and signs of deteriorating credit quality among SMEs and lower-rated borrowers.\n- 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.\n\nSource: IMF blog post by Tobias Adrian, Fabio Natalucci, Jason Wu, July 27, 2023.\n\n---\n\n\n References\n\n- fallen significantly\n\nSource: https://www.imf.org/en/blogs/articles/2023/07/27/inflation-remains-risk-confronting-financial-markets"
    }
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    "Authors: Tobias Adrian, Fabio Natalucci, Jason Wu",
    "Published: July 27, 2023",
    "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.",
    "Year-on-year headline inflation:",
    "Core inflation (excluding food and energy) has declined more slowly; services inflation is particularly sticky.",
    "Market-implied expectations:",
    "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 (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:",
    "Monetary policy operates with considerable lags; pace and timing of transmission remain uncertain.",
    "Bank credit growth:",
    "Large bank earnings:",
    "Nonbank credit provision:",
    "Scenario: underlying inflation remains sticky and declines only slowly.",
    "Financial stability vulnerabilities:",
    "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.",
    "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:",
    "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.",
    "[fallen significantly](https://www.imf.org/en/Publications/WEO/Issues/2023/07/10/world-economic-outlook-update-july-2023?CID=sm-com-bl-WEOET2023004)"
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