On April 16th, the International Monetary Fund (IMF) and the World Bank held a press briefing on the previously released Global Financial Stability Report. Tobias Adrian, the Financial Counsellor and Director of the Monetary and Capital Markets Department of IMF, indicated that as the global fight against inflation enters "the final mile," the near-term risks to global financial stability have receded.
However, he pointed out that there are still prominent risks in this process and medium-term vulnerabilities are accumulating. Recent economic inflation data, which came in higher than expected, could challenge the notion of "the final mile" and the associated investor optimism, potentially leading to market repricing and increased volatility.
In light of the ongoing challenges that the financial sector faces in fighting inflation's "final mile," how does the IMF assess the balance between tight monetary policy and financial stability? With markets betting on the Federal Reserve to soon start cutting interest rates, what significant effects will this have on other countries and regions? What unique challenges do emerging markets face amid the global economic slowdown trend?
Following the press conference, we had an exclusive interview with Jason Wu, Assistant Director of the IMF’s Monetary and Capital Markets Department, to discuss the related issues.
Wall Street Frontline: So the first question, given the ongoing vulnerabilities in the financial sector during the last mile of fighting inflation. How does the IMF assess the balance between tightening monetary policy and preventing financial instability according to the report you released yesterday？
Jason Wu: Having stable inflation is a prerequisite for financial stability and holds the utmost importance. Central banks, therefore, should squarely focus on inflation, adjusting their monetary policies until they are comfortable that inflation targets will be met. Inevitably, situations arise where high inflation coincides with financial instability, such as in March last year when several large banks failed globally, despite persistently high inflation. In these instances, central banks have tools, like liquidity facilities, to lend to the financial sector while still concentrating monetary policy on controlling inflation. This approach has been successfully implemented by several central banks, including the European Central Bank and the Federal Reserve, particularly evident last spring. However, there are circumstances where financial instability is so severe that it demands a monetary policy response. An example of this was seen in the UK during October 2020. In such scenarios, central banks should use all available tools to address financial instability and, simultaneously, communicate with conviction their intention to return inflation to target once financial stress subsides.
Wall Street Frontline: You just mentioned controlling inflation is one of the priorities for central banks. So as the US Federal Reserve continues to navigate between controlling inflation and also promoting economic growth, what are the IMF recommendations for future monetary policy adjustments, especially for the Federal Reserve?
Jason Wu: We find ourselves in what the reporter has termed the last mile of disinflation, yet this final stretch is incomplete and evidently a bumpy one. Disinflation is stalling in many countries, with our progress on inflation being somewhat erratic. In light of this, it is crucial for central banks, whose job revolves around inflation targeting, to see the task through to completion, which means maintaining a suitably tight monetary policy until the goal is achieved. There are some countries where disinflationary progress is more noticeable, and there, central banks might start transitioning to a more neutral policy stance, possibly even considering rate cuts. However, central banks should proceed with caution, particularly concerning potential upsides on inflation before taking such steps. Moreover, given that financial markets sometimes harbor unrealistic or overly optimistic expectations about interest rate cuts, central banks are advised to firmly counter such expectations.
Wall Street Frontline: Given the disparity between emerging markets and developed economies, how does the trajectory of potential interest rate cuts of Federal Reserve may affect different economies?
Jason Wu: The question of how policies undertaken by the Federal Reserve and other advanced economy central banks affect the global economy is crucial, as their actions invariably have spillovers to emerging markets, lower-income countries, and frontier economies. This is an inevitable outcome in our globalized monetary system and financial marketplace. The extent of the impact on these countries hinges on their economic fundamentals, with the interest rate differential with the US being particularly significant. For instance, certain countries in Latin America, which have maintained a large interest rate differential with the US, have shown resilience over the past two years in the face of high US interest rates. This differential creates a buffer for capital flows, sustains a higher exchange rate, and alleviates depreciation pressures. Conversely, countries with a smaller interest rate differential might experience more financial turbulence. Furthermore, countries in stronger fiscal positions with lower external debt tend to be more resilient during periods of high global interest rates, while those struggling to service their external debt are disproportionately affected.
Wall Street Frontline: So can you elaborate what unique challenges do emerging markets face in the context of the global economic slowdown, as well as potential interest rates cut of Federal Reserve.
Jason Wu: As the global economic tide recedes, it's apparent that the buoyancy previously experienced by all markets is diminishing. Emerging economies are entering a phase where their currencies may face downward pressure, and they might see capital outflows as foreign investments pivot abroad. These challenges are not unique to the current cycle or recent years, but they could intensify if high-interest rates persist. Our advice to emerging market economies is to center their attention on domestic conditions, such as inflation, and to employ tools to counteract external pressures. This includes adopting proactive monetary policies and pursuing fiscal consolidation. Furthermore, during particularly turbulent times with excessive stress, we suggest considering foreign exchange interventions as part of our integrated policy framework to mitigate some of the external strains.
Wall Street Frontline: You just talk about the banking crisis last March, which happened to a few of major banks. With significant declines in commercial real estate prices, especially in the US and the European countries, what potential impacts do you foresee in the banking sector of these regions?
Jason Wu: The question raised touches on a critical issue. According to our assessment in the Global Financial Stability Report, we believe that the global banking sector, on the whole, should be manageable. This is due to the ample capital and liquidity present within the system that are expected to absorb the forthcoming losses in the commercial real estate sector, as well as from other borrower segments. However, a key lesson from a year ago is that certain firms will face difficulties. When such firms encounter trouble, systemic repercussions can quickly affect other firms. Consequently, it is crucial for regulators to remain vigilant about this risk. We advise in the report that regulators should proactively enhance their supervisory roles, employ tools like stress tests and early corrective measures to intervene promptly with banks that may be in trouble, and ensure that the impacts, such as those from commercial real estate losses, do not cascade further.
Wall Street Frontline: Do you think the stress test should only be applied to like a few larger banks, or should it be applied to all the banks?
Jason Wu: The decision of how to regulate banks is one that must be made on a jurisdiction by jurisdiction basis. The essential point is that any bank with significant importance to its own economy should be subject to appropriate regulation. While stress testing is just one of many tools available, it remains an important option for regulators to consider. This isn't to suggest that every single bank requires stress testing—considering there are thousands, such as the 4000 in the US or around 6000 in China. It's really a matter of regulatory discretion. From our perspective, it is crucial that any banks that hold significant importance to the economy are regulated properly.
