IMF warns of the dangers of high inflation in emerging economies

IMF’s note published on Wednesday outlines its stance on global prospects and policy challenges.

Global activity has picked up, largely on account of advanced economies, however in many emerging markets, despite a boost to output from stronger exports, domestic demand has been weaker than expected, reflecting in part tighter financial conditions.

A new bout of financial volatility has affected emerging market economies as markets reassess their fundamentals. While the pressures were relatively broad-based, emerging economies with relatively high inflation and high current account deficits saw the largest asset price declines initially. Markets are showing signs of stabilizing recently, although they are still fragile, on the back of actions by key emerging economies to shore up confidence and strengthen their policy commitments. This episode, however, underscores vulnerabilities and the challenging environment for many emerging economies. The rapid jump in global risk aversion had also driven down advanced economy equity prices.

Global growth is projected to increase to about 3¾ percent in 2014 (from 3 percent in 2013) and 4 percent in 2015, similar to the January 2014 WEO Update.

However, the recovery is still weak and significant downside risks remain. Capital outflows, higher interest rates, and sharp currency depreciation in emerging economies remain a key concern and a persistent tightening of financial conditions could undercut investment and growth in some countries given corporate vulnerabilities. A new risk stems from very low inflation in the euro area, where long-term inflation expectations might drift down, raising deflation risks in the event of a serious adverse shock to activity.

Further action and cooperation are needed to promote financial stability and robust recovery. Specifically:

Advanced economies should avoid premature withdrawal of monetary accommodation as fiscal balances continue consolidating. Given still large output gaps, very low inflation, and ongoing fiscal consolidation, monetary policy should remain accommodative in advanced economies. Fiscal consolidation should proceed at a measured pace, while preserving the long-run growth potential of the economy.
In emerging market economies, credible macroeconomic policies and frameworks, alongside exchange rate flexibility, are critical to weather turbulence. Further monetary policy tightening in the context of strengthened policy frameworks is necessary where inflation is still relatively high or where policy credibility has come into question.
Further policy actions are needed to reduce unemployment and strengthen medium-term growth, while making it more balanced.