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Central bankers caught in a debt trap they helped create, IMF says

Rising public and private debt around the world may constrain central bankers' ability to tighten before the next financial slowdown, the International Monetary Fund said in a new report on global financial stability.

The international body attributed much of the buildup of risky debt to investors chasing yield in a low-interest rate environment, the IMF said in its Global Financial Stability Report released Oct. 11.

"There is too much money chasing too few yielding assets: Less than 5% ($1.8 trillion) of the current stock of global investment-grade fixed-income assets yields over 4%, compared with 80% ($15.8 trillion) before the crisis," the report said.

That dynamic pushed asset valuations too high, the report said, with investors willing to overlook credit and liquidity risks to boost returns.

Central bankers thus face a dilemma: A return to normal monetary policies will preserve the tools that will be necessary during the next downturn, but the current accommodative policies support the global recovery and keep asset valuations inflated.

The portfolio adjustments brought on by monetary accommodation may lead to results that cannot be predicted from past financial cycles, the report said. With central banks starting to normalize their policies — even in the face of low inflation — sudden or badly timed changes could spark unwanted volatility in financial markets.

Ballooning debt

Accommodative central banks and the search for yield has also led to a boom in global debt, the IMF said. Total nonfinancial sector debt, which includes borrowing by governments, nonfinancial companies and households, from banks and bond markets, for the G-20 economies is now $135 trillion or about 235% of aggregate GDP, the IMF said. Much of that debt was taken on in the aftermath of the global financial crisis when central banks stepped in to stabilize economies.

Increased levels of household debt also poses risks to the economy and could signal the advent of banking crises, the IMF noted.

"A simple look at the data shows that increases in household debt peak about three years before the onset of a banking crisis," the report said.

The report noted that strengthening underwriting standards, as well as regulating the amount of capital lenders must hold to ensure against losses, were effective measures to guard against another crisis.

Shocks to the system

With market and credit risk premiums near decade-low levels, the IMF said that under a worst-case scenario, credit spreads could rapidly decompress, followed by declines in equity markets of as much as 15% and decreases in home prices of as much as 9%.

The fund said that scenario could emerge by 2020, with the global economic impact being about one-third that of the financial crisis.

The U.S. is likely to be spared most of the economic fallout from such a scenario, mostly because of high capital buffers in its banking industry, even as equity markets are overvalued, the report said.

However, should the worst-case scenario come to pass, the IMF said the Federal Reserve would have to cut its benchmark federal funds rate to 1.75%.

That assessment lends support for the Federal Open Market Committee's current median expectation for a target rate of 2.9% by 2019. Though inflation has remained well below the Fed's 2% target, FOMC members have said that they will need added flexibility to use rates as their primary monetary policy tool should the economy experience a slowdown.