Central banks are said to face the challenge of handling their monetary obligations and satisfying competing requirements (balancing act) amid persistent inflation.
This is because real interest rates remain very low in many countries, and thus, monetary policy tightening must be accompanied by some contraction of financial conditions.
However, the International Monetary Fund (IMF), warned of possible unintended consequences if global financial conditions tighten substantially.
A higher and sudden increase in real interest rates could lead potentially to a disruptive price revaluation and an even larger selloff in stocks; it said it in its latest blog, “Low Real Interest Rates Support Asset Prices, But Risks Are Rising.”
The IMF Blog also notes that as financial vulnerabilities remain elevated in several sectors, monetary authorities should provide clear guidance about the future stance of policy to avoid unnecessary volatility and safeguard financial stability.
Capital flows to emerging markets could be at risk because stock and bond investments in these economies are generally seen as being less safe.
Impact on economic growth
The IMF said: “Our growth-at-risk estimates, which link future economic growth downside risks to macro-financial conditions, could increase substantially if real rates rise suddenly and broader financial conditions tighten.
“Easy conditions helped global governments, consumers, and businesses withstand the pandemic, but this could reverse as monetary policy tightens to curb inflation, moderating economic expansions.”
In addition, capital flows to emerging markets could be at risk because stock and bond investments in these economies are generally seen as being less safe. Therefore, tightening global financial conditions may cause capital outflows, especially for countries with weaker fundamentals.
The authors of the blog, Nassira Abbas and Tobias Adrian, believe supply disruptions coupled with strong demand for goods, rising wages and higher commodities prices continue to challenge economies worldwide, pushing inflation above central bank targets.
“To contain price pressures, many economies have started tightening monetary policy, leading to a sharp increase in nominal interest rates, with long-term bond yields, often an indicator of investor sentiment, recovering to pre-pandemic levels in some regions such as the United States,” the writers said.
According to them, investors often look beyond nominal rates and base their decisions on real rates—that is, inflation-adjusted rates, which help them determine the yield on assets. This is because low real interest rates induce investors to take more risks.
Despite somewhat tighter monetary conditions and the recent upward move, longer-term real rates remain deeply negative in many regions, supporting elevated prices for riskier assets.
Further tightening may still be required to tame inflation, but this puts asset prices at risk. More and more investors could decide to sell risky assets as those would become less attractive.
The analysts noted that while shorter-term market rates have climbed since central banks’ hawkish turn in advanced economies and some emerging markets, there is still a sharp difference between policymakers’ expectations of how high their benchmark rates will rise and where investors expect the tightening will end.