With one breath, IMF Managing Director Kristalina Georgieva urges the world’s central banks, including most notably the Fed, to stay the course of increasing interest rates at a rapid pace to regain inflation control. She does so even as she recognizes the recessionary risk of such a policy course. She makes the judgment that the inflation risk of doing too little monetary policy tightening outweighs the recession risk of doing too much tightening.
With the other breath, in a moment of commendable candor, the IMF in its recently released Global Financial Stability Report warns that the risks to the global financial system have materially increased. They have done so as very rapidly rising interest rates have exposed the many financial market vulnerabilities that built up during a prolonged period of ultra-low interest rates.
The IMF is now warning that world financial markets are at risk of “a disorderly repricing” that will hit emerging and developing countries most severely. By this, the IMF means that we could face further large declines in equity and housing market prices as well as a credit crunch as interest rate spreads widen. The IMF is also not excluding the possibility that after having already fallen by some 25 percent this year, US equity prices could fall by another 20 percent.
In cheerleading the world central banks to keep rapidly raising interest rates, the IMF seems to be overlooking the fact that the Fed’s interest rate increases this year have been the most rapid in the post war period. The IMF also seems to be overlooking the fact that the Fed’s interest rate increases are occurring in the context of the largest shift among the G-7 countries from fiscal ease to fiscal restraint as well as in the context of a more than 15 percent surge in the dollar to its highest level in twenty-four years.
Along with the Fed, the IMF seems to have forgotten Milton Friedman’s sage warning that monetary policy operates with long and variable lags. Had the IMF heeded that teaching, it might have cautioned the Fed to wait and see what the effects of its policy tightening to date might be before charging ahead with its planned unprecedented fourth 75 basis-point interest rate hike and its withdrawal of $95 billion a month in market liquidity through its Quantitative Tightening policy.
To its credit, the IMF recognizes the acute financial market vulnerabilities that characterize the world economy as a result of gross asset and credit market mispricing caused by years of ultra-easy monetary policy. However, the IMF seems to have forgotten that rapid interest rate increases tend to cause asset and credit market bubbles to burst.
As our experience with the bursting of the 2008 US housing and credit market bubble should have taught us, the bursting of bubbles can lead to very deep and prolonged recessions. Those recessions in turn can produce strong deflationary pressures that can make today’s inflationary problems become the least of our economic problems.
Making the IMF’s acquiescence to the Fed’s rapid pace of tightening all the more surprising is the manner in which higher US interest rates are propelling the US dollar to ever higher levels. One would have thought that the IMF would be deeply concerned about the way the strong dollar is exacerbating the rest of the world’s inflation problem and is increasing the emerging market’s debt service burden.
Last year, the IMF was caught asleep at the wheel by going along with excessively expansive US budget and monetary policies that contributed to multi-decade high inflation. It now risks further denting its credibility by going along with a Federal Reserve monetary policy that could contribute to a very hard US and world economic landing.
Author Biography and Expertise: Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund’s (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and multilateral lending agencies.