The IMF has targeted the European Central Bank’s decision to raise rates in its latest World Economic Outlook, suggesting its leaders should show more patience in the tightening process.The IMF cites low core inflation expectations, the likelihood of a decline in commodity prices in the short-term, and excess capacity as the reason why further “normalization” may be unnecessary.
In most European economies, monetary policy can stay accommodative for as long as inflation pressures remain subdued. In advanced Europe, core inflation is projected to remain low because inflation expectations are well anchored and excess capacity is still large in most economies. Also, the impact of recent increases in commodity prices should prove temporary. This argues for low policy rates for now to support the recovery and help offset the dampening short-term effects of fiscal consolidation on domestic demand. Still, central banks will have to keep a watchful eye on wage developments and inflation expectations for potential second-round effects, especially in countries that are most advanced in their recoveries. In the euro area, remaining financial fragilities could hold back growth, justifying a slower pace of normalization. Moreover, the ECB’s extraordinary measures will need to be removed only gradually as systemic uncertainty recedes.
Specifically, in the euro area, asset quality is uncertain, and banks face a wall of maturing debt and therefore remain vulnerable to funding pressures in wholesale markets. The desire to reduce the dependence on wholesale funding has sparked a deposit war in several economies, squeezing bank revenues. Overall, some euro area banks face significant capital shortfalls. To help address such weaknesses, it is critical to reduce uncertainty about asset quality, increase the capital buffers of viable banks, and identify and resolve weak banks. In this respect, some economies (for example, Spain) have made more progress than others.
The IMF appears concerned that a tighter policy environment in Europe could wreak havoc on an already troubled banking sector that has yet to find its feet.