Central banks need to push back against investor optimism to ensure price stability, IMF says, even if that means declines in stocks

Federal Reserve Board Chairman Jerome Powell speaks during a news conference after a Federal Open Market Committee meeting on December 14, 2022 in Washington, DC. The Federal Reserve announced that it will raise interest rates by a 0.5 percentage point to 4.5.

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• Central banks need to brace themselves against investor optimism and hold firm on monetary policy, per the IMF.
• The fund said price stability needed to be prioritized over a potential contraction in the stock market.
• The IMF pointed out that services inflation was unlikely to fall as quickly as price rises for goods.

Central banks will be forced to push back against surging investor optimism to keep prices from spiraling out of control again, the International Monetary Fund has said.

In a blog post published last week, the IMF said central banks were caught in a bind between the temptation to loosen financial conditions in order to avoid a painful recession, and emphasizing that inflationary risks remain elevated as a rationale to continue raising interest rates.

The IMF fell firmly on the latter, encouraging central banks to stand firm against calls to halt a year-long regime of rate increases.

"Central banks should communicate the likely need to keep interest rates higher for longer until there is evidence that inflation—including wages and prices of services—has sustainably returned to the target," the fund said.

The lender argued that history shows high inflation is persistent and can ratchet up again in the absence of decisive tightening by policymakers.

It added that while goods inflation had gradually declined, services inflation was unlikely to abate without significant labor market cooling, with wages increases taking longer to moderate than goods prices.

Finally, the IMF said prolonged periods of rapid price increases can have long-term effects on inflation expectations, as an inflationary mindset becomes entrenched in households and firms.

The financial institution's warnings come against a wave of investor optimism which has helped stock rebound this year after a torrid 2022. The S&P has gained 7.5% since the beginning of January.

Some of that optimism was wiped out by Friday's US jobs report, which pushed unemployment to its lowest rate since 1969 and lessened the likelihood of a premature rate cut by the Fed this year.

Indeed, expectations that the Fed will go ahead with two more 25 basis point hikes this year are coming back to the fore. Atlanta Fed President Raphael Bostic told Bloomberg the Fed could even implement a further hike to tame inflation, which stood at 6.5% in December.

"To be sure, this is an unusual period in which many special factors are affecting inflation, and it is possible that inflation comes down more quickly than policymakers envision," the IMF wrote.

"However, loosening prematurely could risk a sharp resurgence in inflation once activity rebounds, leaving countries susceptible to further shocks which could de-anchor inflation expectations," it added.

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