IMF spillover report highlights tough balancing act for leading economies

Unconventional monetary measures in the world's biggest economies brought the global economy back from the brink last year, but risk triggering an adverse shock once markets begin pricing in higher interest rates. This was the conclusion yesterday of the IMF's third annual spillover report, where it described the balancing act between short-term stimulus and long-term stability as the overriding "dilemma" for policy-makers.

The spillover report, which examines the external effects of domestic policies in the world's five leading economies – the ‘Systemic 5' (S5) – was based on interviews with policy-makers in these and some smaller countries, conducted between February and early June.

It was supplemented for a second year by the IMF's Pilot External Sector Report and finished, the fund noted, before the market turmoil triggered by Fed chairman Ben Bernanke's hints of QE tapering earlier this summer.

The IMF praised the European Central Bank's (ECB) Outright Monetary Transactions (OMT), the EU's restructuring of Greek debt, Japan's ‘Abenomics' push, and similar policies for easing "severe tensions" and prompting positive spillovers to other economies last year.

It noted: "Keeping easy monetary conditions until the recovery is well established is essential, as long as inflation expectations remain well anchored and financial stability is not threatened."

But the report also warned that unorthodox measures risked "attenuating market discipline" and making "seemingly risk-free" the build-up of unviable financial exposures, as well as encouraging the postponement of necessary structural reforms.

"The policy mixes currently in place are unbalanced and this carries large risks of serious adverse spillovers down the road," it noted, adding that failing to find the right pace of monetary normalisation could have "very large negative" effects as well.

The IMF also observed that all five leading economies are still operating below full potential, and as such, are not contributing as much as they could to global output, "If they could somehow close their output gaps," the report said, "global output would be closer to potential by 3 percentage points."

IMF deputy director David Robinson said in a conference call: "These five economies are not doing as well as was hoped a year ago, they're still extensively below potential."

"However," he added, "one important finding of the report is that all of them have undertaken policies without which the negative spillovers could have been really considerable."

The thin line the S5 economies currently walk was further highlighted by the IMF's remark that they were now "at a fork in the road", and that they should pursue policies that would help them close their output gap "without over-stimulating or over-tightening, through spillovers," other economies that do not need it.