Recently, the International Monetary Fund (IMF) pointed out in its latest Global Financial Stability Report that economic uncertainty may not always be in sync with financial market uncertainty. The organization warned that the disconnect between high economic uncertainty and low financial market volatility could persist, but if shocks lead to a resurgence of market volatility, it could have broader impacts on the economy.
The report indicates that if indicators measuring economic uncertainty climb as they did during the global financial crisis, then in the possible outcomes of economic growth rates, the lowest decile of growth rates (also known as "downside tail risks") would decrease by 1.2 percentage points. This means that if the global economy was previously expected to grow by 0.5% under adverse scenarios, it is now expected to contract by 0.7%. These economic impacts vary by country. Moreover, these impacts are amplified when public and private debt levels are high relative to the size of a specific economy.
The report notes that, in general, high economic uncertainty amplifies the difficulty of the so-called "macro-financial stability trade-offs" associated with an accommodative financial environment. When the financial environment becomes accommodative, economic growth expectations are usually revised upwards, and the downside risks to the economy in the first year are reduced. This stems from various factors, such as the decline in interest rates, the rise in asset valuations, the narrowing of credit spreads, and the reduction in stock market volatility. However, an accommodative financial environment increases debt vulnerability, which exacerbates the downside risks to future economic growth.
IMF analysis suggests that the disconnect between the economy and the market increases the likelihood of a sudden increase in financial market volatility and a sharp drop in asset prices following a negative shock.
Furthermore, the IMF believes that policymakers must recognize the potential hazards of economic uncertainty, also because it can generate cross-border spillover effects through trade and financial connections. These spillover effects could trigger the contagion of international financial risks.
The IMF points out that policymakers should help provide more certainty by enhancing the credibility of their frameworks. For example, they can adopt fiscal and monetary policy rules supported by robust institutions. In addition, improving transparency and carefully designing policy communication frameworks can better guide market expectations—this will increase the predictability of policy decisions (and their transmission to the real economy).
"Since high uncertainty exacerbates the impact of debt vulnerability on the real economy, policymakers should actively adopt appropriate macroprudential policies to reduce these risks. This is particularly important when the financial environment is accommodative and seems to be decoupled from the rise in uncertainty in the broader economy. Moreover, fiscal policy should prioritize fiscal sustainability to prevent high public debt from driving up borrowing costs and avoid its reverse impact on macro-financial stability," the report states.