New Telegraph

IMF advises on fighting inflation amid financial turmoil

The International Monetary Fund (IMF) has advised central bank on the possibility of battling inflation amid financial turmoil. In a blog released early in the week, the global lender said recent events had shown central banks and policymakers could deal with sizable financial stress without compromising their inflation- fighting stance. It recalled that regulators and central banks were able to contain contagion from the collapse of Silicon Valley Bank and other US regional banks, as well as Credit Suisse in Switzerland, without retreating on the inflation front. The lender added that the same was true of the Bank of England’s actions to halt the selloff in bond markets that followed the UK government’s tax-cut proposal last September. According to IMF, in times of acute financial stress and high inflation, though, policy trade-offs are more challenging.

“During the 2008 global financial crisis, policies in pursuit of price and financial stability were aligned. As economic activity faltered, the primary question for price stability was how to support aggregate demand to avoid deflation and recession. On the financial stability side, the main concern was to avoid deeper financial distress. Aggressive easing of mon- etary policy allowed the simultaneous pursuit of both objectives. “With inflation now stubbornly high, the two objectives may clash. Central banks have had to raise policy interest rates aggressively to cool activity and bring inflation back to target. After a long period of low and stable inflation and interest rates, many financial institutions had grown complacent about maturity and liquidity mismatches. “Rapidly rising interest rates have stressed the balance sheets of exposed bank and nonbank financial institutions through declining values of their fixed-income assets and increased funding costs. Left unmitigated, these could threaten overall financial stability.

“How should central banks navi- gate this difficult trade-off ? Con- ceptually, we propose to distinguish between times when financial stress remains modest, and times of height- ened financial stress or acute finan- cial crises. “Past episodes of monetary policy tightening have often generated fi- nancial stress. Provided these stress- es remain modest, they shouldn’t pose much of a challenge to achiev- ing both price and financial stability objectives. Increases in the policy rate transmit to the real economy in part by raising borrowing costs for households and firms. “If such modest financial stress leads to an unexpected weakening of aggregate demand, the policy rate path can be adjusted, keeping output and inflation broadly on the same tra- jectory. Central banks have taken this approach in the past. For example, the US Federal Reserve put a hold on raising rates in the early 1990s when it faced a looming credit crunch, even though inflation was running well above desired levels,” IMF said. It also pointed out that in addition, tools other than the policy rate could be used to contain financial stress.

“For example, emergency lending at the discount window or via emergency liquidity facilities can provide support while macroprudential tools, where available, could be loosened. In principle, the use of relatively standard financial stability tools— without the need for additional fis- cal support—should be sufficient in the case of a modest rise in fi- nancial stress, allowing monetary policy to focus on inflation. “Even when financial stresses may seem contained for some time, a number of developments can create adverse nonlinear feedback loops and quickly develop into a full-blown systemic financial cri- sis, a process that was hastened in the recent bank collapses by technology and social media. “Such an environment presents very difficult challenges for central banks. Forceful and timely action by policymakers is required through aggressive financial policies. These include various forms of liquidity support, asset purchases, or possibly direct capital injections. Sufficiently forceful, these interventions could leave monetary policy free to maintain its focus on inflation.

“Critically, the actions needed to forestall a crisis may extend beyond what central banks can do alone. While central banks can extend broad-based liquidity sup- port to solvent banks, they are not equipped to deal with the problems of insolvent firms or borrowers, which must be addressed by gov- ernments. The need for aggressive financial interventions becomes more acute as financial stresses in- tensify and insolvency risks grow, and often requires committing size- able fiscal resources. “This is illustrated in a recent episode in Korea. When the default of a real estate developer last Sep- tember triggered sharp disruptions in short-term funding markets, the Korean government responded with market support measures, including a corporate bond-buying program, while the Bank of Korea provided substantial liquidity sup- port. These actions allowed the cen- tral bank to raise its policy rate in pursuit of its inflation objectives,” the IMF added.

Read Previous

Aig-Imoukhuede Foundation receives award on contributions to public sector reforms

Read Next

Subsidy Removal: CNPP warns govt against worsening plight of Nigerians