MNI INTERVIEW: IMF's Adrian Warns Of Inflation Risk To Markets

Bumps along the last mile of the Federal Reserve's inflation fight could undermine optimism over rate cuts and painless disinflation and lead to an abrupt tightening of financial conditions that pressures weaker banks, Tobias Adrian, head of the International Monetary Fund's monetary and capital markets department, told MNI.

Oil price spikes from an intensification of geopolitical tensions are yet another imaginable catalyst for financial tightening, he said. Even as stability risks have receded in recent months and the bank turmoil of last spring looks contained, valuations for bonds, stocks and some commodities are stretched and any sudden adjustment in their prices could test the financial system, Adrian said in an interview as the IMF released its latest Global Financial Stability Report.

"There’s a risk-off mood in markets at the moment. There could be a tightening of financial conditions," Adrian said in an interview. "If we did see significant adverse shocks, intensifications of political tensions and war, that could put upward pressures on oil markets. It could trigger repricing in stocks and bonds and that could put institutions under pressure.

"The baseline is very benign, but there are risks around the baseline, and in every country we do see some weaknesses, some tail of weak corporates, weak banks."

STICKY INFLATION

A brighter U.S. economic outlook since October goes "hand in hand" with inflation looking stronger than expected, Adrian said. U.S. CPI has been moving sideways this year and in particular he worries about sticky services prices.

"Market pricing of inflation, the difference between nominal and real yields, has seen a remarkable shift up in the short term," he said, adding commodities prices have also rallied on escalating tensions in the Middle East and could push higher.

"The Fed will do what it takes to get inflation back to target. But how aggressive monetary policy will be and how long it’s going to take to get back there is where the uncertainty lies." (See: MNI INTERVIEW: One Fed Cut Most Likely 2024 Outcome-Keister)

The IMF's baseline outlook is for U.S. rate cuts by end of the year and beyond, but it's urged central bankers to avoid premature easing. "Monetary policy is data dependent. We cannot rule out in some states of the world that rates wouldn’t be cut and there could be even be hikes," Adrian said.

CRE RISK

Higher borrowing costs would likely exacerbate troubles facing commercial real estate borrowers who are already exposed to rising default rates, Adrian said. USD600 billion worth of U.S. commercial real estate debt is due this year. CRE prices have declined 12% globally over the past year in real terms, with the U.S. and European office sectors seeing the largest declines.

"We worry some segments of banks have particularly strong exposure to CRE. It’s a combination of potentially fragile funding sources and exposure to the source of risk," Adrian said.

More than 100 U.S. banks, mostly small and medium-sized and representing about 3% of assets system-wide, have a high concentration in CRE exposure, unrealized losses greater than 25% of Tier 1 capital, and a ratio of uninsured deposits to total deposits greater than 25%, according to the GFSR.

"In terms of the macro economy it's manageable, in terms of global capital markets it’s manageable, but for some institutions it’s worrisome," Adrian said.

"In adverse scenarios, there could be quite intense pressure on corporate borrowers, some sovereigns and some banks -- even if the banks are broadly safe."