The International Monetary Fund has said in a blog that central banks must be resolute in their fight against inflation and ensure policy remains appropriately tight long enough to durably bring inflation back to target.
What Happened: Authors Tobias Adrian, Christopher Erceg and Fabio Natalucci said falling energy prices are reducing headline inflation and fueling optimism that monetary policy may be eased later this year. Such expectations have caused a sharp decline in global longer-term interest rates and boosted financial markets, they stated while arguing that investors may be too sanguine about progress on disinflation.
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“This easing of financial conditions during a central bank tightening cycle creates a conundrum for policymakers,” they said.
Major Wall Street indices have rallied after the Federal Reserve dialed down the pace of its rate hike to 25 basis points on expected lines and Chairman Jerome Powell acknowledged inflation has begun declining.
The SPDR S&P 500 ETF Trust SPY has gained close to 3% in the last two days, while the Invesco QQQ Trust Series 1 QQQ rose over 6%.
Restrictive Rates: Financial markets are signaling that disinflation may occur without meaningful increases in unemployment and policymakers could embrace that view and in effect, ratify the loosening of financial conditions, the authors said.
“Alternatively, central banks could push back against investor optimism, emphasizing the risks that inflationary pressures may be more persistent than expected. This risk-management approach would require restrictive interest rates for longer until there’s tangible evidence of a sustained decline in inflation,” they said.
The authors elaborated on the reasons why such an approach is needed to ensure price stability. They believe high inflation is often persistent—and may possibly ratchet up further — without forceful and decisive monetary policy actions to rein it.
Central banks must also avoid misreading sharp declines in goods prices and easing policy before services inflation and wages, which adjust more slowly, have also moderated markedly, they said.
“Loosening prematurely could risk a sharp resurgence in inflation once activity rebounds, leaving countries susceptible to further shocks which could de-anchor inflation expectations,” they said.
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