IMF: EUROPEAN AND BRITISH CENTRAL BANKS SHOULD RAISE INTEREST RATES CAUTIOUSLY TO GUARD AGAINST EMERGING FINANCIAL STRESS

The International Monetary Fund has warned that the ECB should be alert to potential dangers before sticking to the path of further interest rate rises, including more financial stress and a divergence in bond yields. The risk of inflation puts the onus on policymakers to continue tightening monetary policy, but even so they need to remain flexible to prevent more tensions similar to the US banking turmoil, it said in a report on Friday.

"While average capital and liquidity buffers between banks in the euro area and the United Kingdom have mitigated the impact of the turmoil in the US banking sector, recent problems in the banking sector show how liquidity strains and financial stress can surface suddenly," the IMF said. "Another stressful event could erode buffers, particularly for those banks with weaker fundamentals, and lead to a sharp tightening of credit and broader financial conditions."

"Underlying inflation is high and likely to persist longer than expected," the IMF said. Policy makers need to keep monetary policy tight until core inflation falls back unequivocally to the central bank's inflation target." "Another factor pointing to inflation risks is evidence that, after successive shocks, there may be even less economic slack than expected in many European economies."

Alfred Kammer, head of the IMF's European department, stressed the need to stick to the austerity course. "The worst thing you can do when fighting inflation is to ease too early or pause too early, because that will lead to a second tightening and increase the cost of the anti-inflation effort," he said.

In addition, the IMF said that while inflation risks in the UK were now more balanced, monetary policy may need to be tightened further to stabilise inflation expectations and bring inflation back to target.

The IMF now expects the ECB to raise interest rates by another 75 basis points to 3.75 per cent. "The euro area needs to raise policy rates further, while central banks in emerging Europe should stand ready to tighten policy further in the face of low real interest rates, tight Labour markets and persistently high underlying inflation," the IMF said in its report.

The IMF said that while the ECB could continue quantitative tightening by shrinking its balance sheet, it should also proceed cautiously. "Financial fragmentation -- including sharp divergence in sovereign borrowing costs -- and broader financial stability risks require caution and flexibility to change course when necessary," the IMF noted. It added that "severe bond market turmoil may be a longer term risk".