IMF Says Countries Should ‘Buckle Up,’ Move To Financial Stability Could Be Bumpy

Primary challenge is normalization of U.S. monetary policy

Emerging markets must prepare for likely external shocks

Euro area corporate debt overhang must be addressed comprehensively

The IMF’s analysis outlined five transitions with global impact:

• The expected unwinding of accommodative monetary policy in the United States;

• A move to a more balanced and sustainable financial sector in emerging economies;

• The drive to bolster weak banks and corporates in the euro area;

• Efforts to reinvigorate Japan’s economy through “Abenomics”; and

• The strengthening of global financial regulation.

The road to normal monetary policy

The primary challenge for policymakers is to manage the current side effects—and the eventual withdrawal—of easy money policies such as low interest rates and bond buying by the U.S. central bank.

Given the prospect of higher interest rates and greater volatility, investors will naturally adjust their portfolios by reducing their fixed income holdings. But there is a risk that by selling too much too fast, long-term interest rates could rise more sharply than presently anticipated.

“There may be bumps in the road to monetary normalization,” said Jose Viñals, Financial Counsellor and head of the IMF’s Monetary and Capital Markets Department. “The question is whether the bumps will make the trip merely uncomfortable, or whether some of them are likely to lead to accidents.”

One of the challenges is the sheer magnitude of the likely portfolio adjustment. The IMF estimates that, since 2009, cumulative U.S. mutual fund inflows into fixed income have exceeded their historical trend by more than $1 trillion. This has raised the risk of large withdrawals in the event of monetary tightening.

Another challenge is the “weak links” in the U.S. shadow banking system, such as mortgage real estate investment trusts. Like the structured investment vehicles and the conduits that mushroomed before the crisis, mortgage real estate investment trusts are highly leveraged and susceptible to funding runs. They could be forced to sell their asset holdings quickly, causing disruption in the mortgage-backed securities market, which could spread to broader asset markets.

Engineering a smooth transition to normal monetary policy will require a clear and well-timed communication strategy by the U.S. central bank to minimize interest rate volatility. It will also require effective strategy execution, according to the IMF. Increased oversight of...