Overall inflation has moderated meaningfully in recent months in the United
States and euro area, as energy and food prices have fallen significantly. Year-on-year headline inflation is now around 3 percent in the
United States and below 5.5 percent in the euro area. However, core
inflation, excluding food and energy prices, has declined more slowly.
Services inflation has proven to be particularly sticky.
According to market pricing, investors expect headline inflation to
continue to decline quite rapidly in coming quarters. However, some market
participants still see upside risks to the inflation outlook, likely
reflecting recent stickiness in core inflation. Indeed, pricing from
inflation options—financial instruments that offer protection against
inflation moving higher or lower than its current level—shows that such
upside risk is particularly pronounced in Europe, where investors assign
roughly similar odds to inflation returning to the European Central Bank’s
2 percent target and inflation remaining around 4 percent. In the United
States, investors appear to put high odds on inflation being above target
at around 3 percent.
At the same time, financial conditions—as proxied by our index that
summarizes financing costs faced by firms and households in housing,
credit, and equity markets—have eased notably in the United States and euro
area in recent quarters. This easing has occurred despite continued
monetary policy tightening by the Federal Reserve and ECB, in part
reflecting investors’ relatively benign outlook for price pressures—an
assessment that has boosted market valuations.
The recent easing creates a challenge for central banks in their efforts to
get inflation back to their 2 percent targets. Historically, tighter
monetary policy has been transmitted to the real economy, and subsequently
to inflation, through tighter financial conditions. While financial
conditions are currently tighter than the extremely loose levels seen in
mid-2021, the recent easing may complicate the fight against inflation by
preventing the slowdown in aggregate demand that may be needed to tamp down
inflation pressures.
A further complication results from the combination of a prolonged period
of extremely loose financial conditions and a monetary policy tightening
cycle in advanced economies that started when inflation was already
elevated. This may have dulled the transmission of monetary policy to
financial conditions. For example, the share of fixed-rate mortgages with
low rates (because of refinancings in the past few years) is very high in
the United States. Similarly, corporations took advantage of exceptionally
low borrowing costs and ample liquidity to extend their debt maturities.
In both cases, this may have dampened the effectiveness of monetary policy
tightening, as many mortgage holders and companies have only begun to face
higher borrowing costs, thus contributing to the continued strength in
labor markets and aggregate demand. Of course, other factors may have
played a role, including structural changes in the labor marker or housing
markets after the pandemic, for example.
While financial condition indices based on financing costs in capital
markets have eased, monetary policy transmission also works through credit
extension, especially for borrowers more reliant on bank lending. Bank
credit growth has remained positive in both the United States and euro
area, although the pace of growth has slowed markedly, especially in the
latter. More forward-looking information in recent loan officer surveys in
both the United States and euro area point to significantly slower demand
for credit and tightening underwriting standards by banks, suggesting that
a further deceleration in bank credit provision may be in the offing.
Recent earnings reports have shown strength at large banks, with earnings
boosted by higher interest rates charged on loans while remuneration on
deposits continues to lag the pace of policy tightening. Lending survey
results, however, suggest that profitability could moderate going forward.
Nonbank credit provision may also be slowing, with corporate bond issuance
down significantly this year. Importantly, we also see a pronounced
differentiation: while issuers with high credit ratings continue to be able
to borrow relatively easily, their lower-rated counterparts face greater
headwinds. Default rates are starting to increase among lower-rated
borrowers, albeit from low levels, along with bankruptcies at small and
medium-sized enterprises. This suggests the credit cycle may be
deteriorating.
Monetary policy has always operated with considerable lags, and the pace
and timing of transmission of the tightening remains uncertain,
particularly given possible structural changes in the economy due to the
pandemic and rising geopolitical tensions. The central narrative among
market participants is one of a benign soft landing, where inflation
returns to target relatively quickly with only a modest slowdown in
economic growth. While IMF’s baseline outlook doesn’t foresee recession in
the United States or euro area, core inflation is expected to be more
persistent than what is priced in markets, and consequently, further policy
tightening is assumed.
But a scenario where underlying inflation continues to be sticky and
declines only slowly is a risk. Tighter monetary policy for longer than
currently priced by financial markets may be needed, resulting in higher
real interest rates. This could hurt investor sentiment as market
participants reassess the inflation and policy outlook, leading to a
repricing of risk assets such as equities and credit and to a tightening of
financial conditions. Such an outcome could heighten risks to economic
activity and financial stability.
Potential vulnerabilities
From a financial stability standpoint, strategies predicated on a fast
disinflation process and a soft landing could be vulnerable to an abrupt
tightening in financial conditions and the unwinding of highly leveraged
investment strategies may lead to disorderly market conditions.
For example, there are now widespread reports and anecdotal evidence in the
United States of investors financing purchases of Treasury securities and
simultaneously selling futures contracts to capture profits from the
difference in prices. A sudden shock, for example related to upside
surprises to inflation, may cause a widening of such price differences and
force leveraged investors to unwind their positions, selling bonds just as
the prices for those securities fall. The potential for an adverse feedback
loop between such forced selling and banks that do not have the balance
sheet capacity or willingness to buy these securities could lead to stress
in markets and present financial stability challenges reminiscent of those
that shook Treasury markets in March 2020 at the onset of the pandemic.
In addition, some segments in the US banking sector remain vulnerable as
regional lenders may continue to face profitability issues in the quarters
to come. The March banking turmoil in the United States and the
government-supported sale of Credit Suisse underscored that managerial and
supervisory failures can make banks vulnerable to shifts in market
sentiment, with investor runs amplified by technology and social media.
Both pricing and positioning suggest that investors are perhaps too
optimistic about the speed of disinflation and the likelihood of a soft
landing in economic activity. Core inflation remains sticky, suggesting
that inflation (and the risk of a resurgence) has not yet been fully tamed.
History cautions against declaring victory too soon. Central banks must
remain determined in their fight until there is tangible evidence that
inflation is sustainably moving toward targets.