Central Banks to Play Key Role in Alleviating Current Crisis

The global financial crisis caused by inflationary pressures and their influence on consumer behavior has limited economic growth and led to the build-up of financial vulnerabilities. Countries such as Mexico have seen their economic growth estimates contract as local and international risks to financial stability increase, warns the International Monetary Fund (IMF). 

“Financial vulnerabilities are elevated in the sovereign and non-bank financial institution sectors, while market liquidity has deteriorated in some major asset classes,” said the International Monetary Fund (IMF) in its October Global Financial Stability Report. 

This year, global financial conditions have become increasingly tight, causing capital outflows from emerging economies. The global economic outlook has also deteriorated compared to what was expected in April 2022, according to the IMF. In the new report, the IMF forecasts that Latin America and the Caribbean will grow by 3.5 percent in 2022 and 1.7 percent in 2023. The rates are 0.5 points higher than the July 2022 forecast thanks to favorable commodity conditions, favorable external financing conditions and the region’s relevance in recent years. Despite the optimistic case for Latin America, the IMF decreased Mexico’s economic forecast from 2.4 percent to 2.1 percent and maintains its projection for 2023 at 1.2 percent.

Central banks, such as Mexico’s Banxico, have tightened monetary policies to constrain inflation. The macroeconomic environment, in turn, puts pressure on the global corporate sector and many large companies continue to report a contraction in profit margins due to rising costs. Against this backdrop, the IMF comments that central banks must invest in bringing inflation back to target to prevent inflationary pressures from becoming entrenched and inflationary expectations from unwinding; otherwise, their credibility could be undermined.

“Authorities must prevent further accumulation of financial vulnerabilities,” said IMF. The trade-off is considered to be between containing the build-up of vulnerabilities and avoiding procyclicality and a disorderly tightening of financial conditions.

Since this crisis involves both supply and demand shocks, the traditional notion of countercyclical demand management through monetary policy is less relevant, according to the Inter-American Development Bank. Central banks are in different positions with respect to the room they have to reduce rates and the potential benefits of such policies. The margin depends not only on the level of the policy rate but also on the degree of anchoring of inflation expectations. Finally, and as has been demonstrated in previous periods of uncertainty, central banks should have a clear communication strategy with the general public to reduce uncertainty. Communication will also help to explain the temporary nature of the measures adopted and the strategy for phasing out many of these policies.