Countries will face risks of financial instability if central banks do not manage well the winding down of their easy-money monetary policies, the IMF said Thursday. Risks do not necessarily come from the extremely low interest rates and high liquidity measures many major central banks have taken since the 2008 financial crisis, the International Monetary Fund said in its newest Global Financial Stability Report.
The challenge is more in managing the resumption of conventional monetary policies, it said, especially if damaged banks have not yet fully repaired their balance sheets and remain dependent on highly accommodative monetary policies, the IMF said. As monetary policy is tightened, higher interest rates may increase credit risk for banks, particularly if the rate increase is driven by a perceived inflation threat rather than from improvement in the economy.
Higher rates also could spur bank losses on fixed-rate securities in the short term, weighing on weakly capitalised banks, the global lender said. "Even though monetary policies should remain very accommodative until the recovery is well established, policymakers need to exercise vigilant supervision to assess the existence of potential and emerging financial stability threats," the Fund said.
The IMF warned that a disorderly exit could also unhinge currently well-anchored inflation expectations. "Policy missteps during an exit could affect participants' expectations and market functioning, possibly leading to sharp price changes." The IMF analysis concluded that central banks' extraordinary measures to battle the crisis had improved soundness in the domestic banking sector and contributed to financial stability in the short term. But the longer they policies are in place, the greater the risk of unwanted outcomes, it said. The report looks at the exceptional monetary policy of the Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan.
All four lowered interest rates and pursued other unconventional policies, including large bond-purchase programs, or quantitative easing, to inject liquidity into economies and ease credit. "The exceptional nature of current monetary policies and the relatively untested macroprudential tools in many countries make this uncharted territory for policy makers," it said.
The IMF called on policy makers to carefully monitor the effectiveness of their policy mix. It pointed out that financial stability risks may be shifting to other parts of the financial system, such as shadow banks, pension funds, and insurance companies.