Financial Stability Risks Grow as War Complicates Push to Contain Inflation

While no systemic event has materialized, the balance of risks has tilted more firmly to the downside.

Russia’s invasion of Ukraine raises financial stability risks for the world and poses questions about the longer-term impact on economies and markets. The war, amid an already slowing recovery from the pandemic, is set to test the resilience of financial markets and poses a threat to financial stability as discussed in our latest Global Financial Stability Report.

Ukraine and Russia face the most pressing risks. Yet it is already clear that the severity of disruptions in commodity markets and to supply chains are creating downside risks by weighing adversely on macrofinancial stability, inflation, and the global economy.

Since the beginning of the year, financial conditions have tightened significantly across most of the world, particularly in Eastern Europe. Amid rising inflation, expected interest-rate hikes have led to a notable tightening in advanced economies in the weeks following the Russian invasion of Ukraine. Even with that tightening, financial conditions are close to historical averages, and real rates remain accommodative in most countries.

Tighter financial conditions help to slow demand, as well as to prevent an unmooring of inflation expectations (that is, where anticipation of continued price increases in the future becomes the norm) and to bring inflation back to target.

Many central banks may have to move further and faster than what is currently priced in markets to contain inflation. This could bring policy rates above neutral levels (a “neutral” level is one at which monetary policy is neither accommodative nor restrictive and is consistent with the economy maintaining full employment and stable inflation). This is likely to lead to even tighter global financial conditions.

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