As we traverse the final stretch in the global battle against inflation, central banks worldwide stand at a critical juncture. The recent optimism that has pervaded financial markets, buoyed by the belief that the end of inflationary pressures is within reach, may be premature. Indeed, the path ahead is fraught with potential pitfalls and requires unwavering vigilance.
The Illusion of the Final Mile
Despite the upbeat sentiment that has led to a robust rally in global stock markets and the narrowing of corporate and sovereign borrowing spreads, the journey is far from over. The latest Global Financial Stability Report highlights the uneven terrain that lies ahead. Geopolitical tensions, which could escalate and sour investor sentiment, are just one of the many challenges that could destabilize the current trajectory. The commercial real estate market is under increased strain, potentially exerting greater pressure on lending institutions. China’s financial markets continue to grapple with the persistent issues plaguing its real estate sector. Beyond these immediate concerns, vulnerabilities due to rising debt levels persist, with both public and private sectors heavily leveraged, despite high-interest rates and the likelihood of subdued economic growth, contrary to World Economic Outlook projections.
A closer look reveals that the downtrend in inflation experienced by some nations may have stalled, with underlying inflation persisting in certain sectors. In some instances, core inflation rates have consistently exceeded analysts’ forecasts for several months, challenging the narrative of the ‘final mile’ and the accompanying investor optimism. This could lead to a re-pricing in financial markets and heightened volatility.
Sticky Inflation: A Persistent Challenge
After a rapid deceleration of inflation globally, a divergence has emerged among nations. Recent data indicates an uptick in the core inflation rates in major developed and emerging economies, including the Czech Republic, France, Germany, Italy, the Philippines, South Africa, Sweden, the UK, and the USA, compared to the preceding three months.
Investors seem to anticipate that price pressures will not abate swiftly. Inflation expectations for the next couple of years in major economies, reflected in the difference between nominal government bond yields and inflation-linked government bond yields, have risen once again. The crucial concern is that they remain above the central banks’ target levels—2% for France, the UK, and the USA, and 3% for Brazil and Mexico. Other measures of inflation expectations, such as those derived from household surveys, appear more stable.
The Risk of Repricing
Before volatility in asset prices spikes, a divergence often occurs between volatility and uncertainty. Investors, when faced with adverse shocks, reassess asset values to account for heightened uncertainty, leading to significant increases in asset price volatility.
One potential adverse shock on the ‘final mile’ could be inflation levels exceeding expectations. While inflation expectations, as mentioned, may rise in some countries, investors anticipate significant cuts in policy rates this year—with the European Central Bank and the Central Bank of Brazil expected to reduce rates by approximately 75 basis points. Despite a series of higher-than-expected inflation rates in the USA, the Federal Reserve is projected to cut rates by about 50 basis points. Investors seem to believe that data-driven central banks will ease monetary policies as inflation slows further. However, if inflation remains stubbornly high, these lofty expectations may be dashed, potentially triggering a sell-off in bonds, stocks, and even cryptocurrencies.
In such a scenario, financial conditions would tighten universally. The most immediate consequence would be that some investors, especially those with leverage, would face losses on their assets, with negative returns magnified. Globally, borrowers would find it more challenging to service debts as bond yields rise.
Emerging market borrowers, in particular, would face significant impacts. Many issuers are already contending with refinancing rates higher than the yields on outstanding dollar-denominated sovereign bonds. The most vulnerable emerging markets, rated B and CCC or lower, face the largest rate increases. A tightening of the global financial environment driven by inflation would make refinancing even more difficult.
Maintaining the Fight Against Inflation
The stall in the inflation deceleration trend may catch investors off-guard, as they increasingly believe that the fight against inflation has been won and that we are headed back to an era of low interest rates. For economies where inflation rates persist above target levels, central banks should not ease monetary policies prematurely, lest they be forced to retighten later. Central banks must also temper investors’ overly optimistic expectations of policy easing, which has induced a certain exuberance in financial markets. Of course, if progress in the fight against inflation indicates that it is steadily converging towards the target, central banks should gradually lessen the degree of policy tightening.
To maintain financial stability on this ‘final mile’, a multifaceted approach is essential. Financial regulators should take measures to ensure that banks and other institutions can withstand risks such as defaults, utilizing stress tests, early corrective actions, and other regulatory tools. Regulators should focus on the comprehensive and consistent implementation of internationally recognized prudential standards, particularly completing the phased implementation of Basel III. Further progress in recovery and resolution frameworks is also critical to limit the impact of failing institutions. Central banks must ensure that banks can access liquidity facilities when needed and stand ready for early intervention to alleviate funding pressures in the financial sector.
