Probability & Partners: Views of DNB, the IMF and the BIS as ingredients for scenarios?

July 2, 2024

On June 30, the Bank for International Settlements (BIS) published its annual report. Slightly earlier, DNB and the IMF had published their reports on financial stability.[1] The three institutions regularly publish about their expectations for the economy and the financial markets. The uncertainties identified around their expectations are particularly interesting for asset managers and risk managers.

The organizations are not all-knowing, but due to their large research capacity, bright minds and detailed studies, the visions are always well substantiated.

Inflation expectations

When it comes to inflation forecasts, there is quite a bit of overlap between the expectations of the IMF and DNB. Both organizations expect a further decline. Their reasoning is similar: tight monetary policy is a strong driver for controlling inflation. The importance of a good monetary policy is recognized by all three. The IMF and DNB expect that the pace of price increases will move closer to the central banks' targets, which will lead to better economic prospects. All in all, they are optimistic about the future.

However, the BIS is a bit more gloomy when it comes to inflation. They expect high inflation to persist over a longer period. Although all three organizations consider potential shocks possible, the BIS seems to take them a lot more seriously.

The reasoning outlined by the BIS has six factors. First, the pressure on global supply chains is mentioned and linked to factor two: geopolitical tensions. If markets lean more towards domestic production to reduce dependence on supply chains, this could lead to inflation shocks. We have seen this in Europe around energy prices. Furthermore, possible sanctions due to geopolitical developments also have a strengthening effect on inflation.

The third factor mentioned is budgetary policy. While the IMF and DNB describe the effect of monetary policy as positive, the BIS also talks about additional risks. Prolonged fiscal stimulus could lead to demand-pull inflation, and a prolonged period of accommodative monetary policy could also fuel inflation, especially as expectations for long-term interest rates are on the low side.

Factor four concerns the labor market. Tight labor markets ensure that wages can rise, after which a wage-price spiral can arise. Demographic developments are also mentioned. An aging population means less labor participation, which can also put pressure on wages and inflation.

The BIS then sees a possible substantial effect of climate and transition risk on costs and price increases. Climate-related shocks within supply chains and the agricultural sector, as well as rising costs for the transition to a sustainable economy, can both lead to upward shocks in prices. These factors are also mentioned by the IMF and DNB, but not explicitly linked to the inflation rate.

The final driver for inflation is the debt level. When debt levels are high, central banks are less willing to raise interest rates to combat inflation, if the impact of high interest rates on highly indebted entities can be seen as a threat. Although DNB and the IMF do not mention this explicitly, they do emphasize the importance of coordination between fiscal and monetary policy.

Expectations for interest rates and stock prices

Due to their view on inflation, the BIS is also the only one that expects that interest rates could be higher in the longer term. If inflation is high due to the factors mentioned, interest rates will be adjusted upwards again to cool down price increases. DNB predicts a moderation in interest rates in the longer term, as it expects disinflation to continue, mainly by stabilizing the economy. This contrasts somewhat with the BIS, which places more emphasis on potential shocks.

The IMF's expectations here are also largely in line with DNB. Both institutions predict relatively low interest rates in the longer term. The IMF's reasoning is also very similar to that of DNB.

Views on the stock market are less divided. The organizations all mention the current optimism, overvaluation, strong corporate profits and (anticipation of) low interest rates.

While all three recognize the current high valuations on the stock markets and the potential risks of market corrections, DNB focuses more on regional and sector-specific vulnerabilities, the IMF on global interconnectedness and structural trends, and the BIS on market vulnerability and the need for policy normalization.

Internal politics

What struck us is that greater contradictions in the electorate, strong radicalization within the political spectrum, and problems with governability - which we see in many countries - are hardly addressed by the three institutions. These phenomena are visible in the US, the UK, and several countries in Europe and South America. With the rise of right-wing and left-wing populism, structural reforms are becoming less likely. Mainly the BIS, but also the IMF and DNB, mention the need for structural reforms to promote financial stability. The interaction between fickle voters, the ability to govern and therefore the chances of successfully implementing more structural reforms in labor, housing, goods, healthcare, and other markets is largely missing from all reports.

Our vision

Reading the reports certainly provides a good picture of the facts surrounding the current economic situation and financial markets. That alone makes them worth reading. The reports primarily provide guidance for policymakers. What is more interesting for us: the reports offer many ingredients for scenario analyzes and stress tests. As far as we are concerned, the BIS annual report is the most interesting on this point. The attention to the supply side of the economy and the vulnerabilities therein, with consequences for inflation, interest rates and financial markets, certainly provide food for thought and good input for scenarios, for example for the ERB for pension funds and the ORSA for insurers.

Probability & Partners is a Risk Advisory Firm that provides integrated risk management and quantitative modeling solutions to the financial sector and data-driven enterprises.