Credit: UNITED STATES - AUGUST 23: A man walks by the Marriner S. Eccles Federal Reserve Board Building on Constitution Avenue, NW, August 23, 2016. (Photo By Tom Williams/CQ Roll Call) (Newscom TagID: rollcallpix100160.jpg) [Photo via Newscom]

A Bumpy Road Ahead for the Global Financial System

April 18, 2018

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[caption id="attachment_23337" align="alignnone" width="3478"] An unexpected increase in inflation could prompt the Federal Reserve and other central banks to raise interest rates faster than currently anticipated, roiling financial markets (photo: Tom Williams/CQ Roll Call/Newscom).[/caption]

The current economic environment remains favorable, but short-term risks to global financial stability have increased in the past six months, as a result of a spike in stock-market volatility in February and continuing investor concerns about rising geopolitical and trade tensions. Looking ahead, the odds of a downturn remain elevated, and there’s even a small chance of a global economic contraction over the medium-term.

Policy makers should take advantage of this favorable environment to take steps that will reduce the risks. For emerging-market economies, this means strengthening economic fundamentals and buffers against external shocks; for advanced economies, it means deploying and developing their regulatory and financial policy tools and following through on plans to strengthen financial institutions.

The global financial stability assessment contained in the latest Global Financial Stability Report (GFSR) is based on the new “Growth-at-Risk” approach that links financial conditions to the distribution of future economic growth. Given current financial conditions, risks to financial stability and growth are high over the medium-term. This reflects the fact that recent years of low interest rates—needed to support economic growth—have provided an environment in which vulnerabilities have been building. These vulnerabilities could exacerbate the next economic downturn and could also make the road ahead bumpy.

How could today’s financial vulnerabilities make the road bumpy? Larger imbalances mean that any shock to the economic or financial system would trigger a more painful adjustment. For example, a faster-than-anticipated increase in US inflation could cause the Federal Reserve and other central banks to withdraw monetary accommodation more quickly than is currently expected, and that could shake financial markets. Another risk is a wider escalation of protectionist measures, which would take a toll on financial markets as well as growth. In either case, a sudden decline in asset prices could expose vulnerabilities in the financial system.

The report identifies three areas of vulnerability: weakening credit quality; external debt-related vulnerabilities in emerging markets and low-income countries; and dollar liquidity mismatches among banks outside the United States. Let’s consider each in turn.

The global economic recovery has so far been resilient to the pronounced swings in financial markets—but investors and policy makers shouldn’t take too much comfort from that fact. They should remain attuned to the risks associated with rising interest rates, elevated market volatility, and increasing protectionism. The road ahead may well be bumpy.

For an explanation of the new “Growth at Risk” model, click here .

To listen to Podcast click here.

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