International Monetary Fund

Extraordinarily loose monetary policy risks sparking credit bubbles that threaten to tip the world back into financial crisis, the International Monetary Fund warned on Wednesday.

In its global financial stability report, the fund cautioned that policy reforms were needed urgently to restore long-term health to the financial system before the long-term dangers of monetary stimulus materialised.

Without more progress, the IMF said “the global financial crisis could morph into a more chronic phase, marked by a deterioration of financial conditions and recurring bouts of financial instability”.

In the short term, however, the fund was more upbeat. José Viñals, IMF head of financial stability, said: “Spring has arrived to global financial markets where after very rainy days and threatening clouds, we are beginning to see some blue skies and more sunny days.”

The IMF believes unorthodox monetary policies to encourage growth are better than other options, but is concerned that the long-term consequences of such strategies represent a “new risk” to financial stability.

“When the patient is still under treatment, you should not suspend the medicine, but you should always be vigilant about the side-effects of this medicine,” Mr Viñals said, adding that central banks could not be the “only game in town” to support economic growth.

The report warned that when the time came to end extraordinarily loose monetary policy, the effects could expose vulnerabilities among companies and households facing higher long-term interest rates, destabilise credit markets and reverse capital inflows to emerging economies.

Given these risks and the continued need for stimulus, Mr Viñals advised central banks to maintain extremely low interest rates and money-printing operations. “Lifting interest rates and exiting from these policies now …would be extraordinarily detrimental, not only for the economy, but also for financial stability”.

The fund added that there was a sustained need to improve the health of banks in both the eurozone’s troubled eurozone and its core. “Many banks in the euro area periphery remain challenged by elevated funding costs, deteriorating asset quality and weak profits,” the IMF said.

The fund repeated its advice that the eurozone needed to introduce a single resolution regime for banks, providing common backstops and deposit guarantees.

In the US, the IMF thought the banking industry’s restructuring was largely complete and that the authorities needed to begin to think about the side-effects of loose monetary policy, which was encouraging some investors to buy much riskier assets and motivating banks to lower lending safeguards. “While we are at the very early stage [of the US recovery], we are already seeing a deterioration in the quality of issuance, which is typical of the late stages of the credit cycle,” Mr Viñals said.

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