IMF Warns of Upside Inflation Risks, Danger of Too Much Government Spending

Gas prices at a gas station in Chicago on May 21, 2024. Scott Olson/Getty Images

The International Monetary Fund (IMF) has issued a warning about a jump in upside risks to inflation, driven by elevated service-sector costs and exacerbated by too much government spending and the forces of deglobalization, which could prompt the U.S. central bank to hold interest rates higher for longer and so dim prospects for a soft landing.

The warning came in a combination of a blog post penned by Pierre-Olivier Gourinchas, the IMF’s director of research, an overview of the organization’s latest edition of the World Economic Outlook report, and the full report itself.

“The good news is that, as headline shocks receded, inflation came down without a recession,” Mr. Gourinchas wrote in the blog post. “The bad news is that energy and food price inflation are now almost back to prepandemic levels in many countries, while overall inflation is not.”

The IMF predicts that inflation across the world, including in the United States, will decelerate more slowly in the latter half of the year, mostly because of rising services prices.

“Services inflation is holding up progress on disinflation, which is complicating monetary policy normalization,” the IMF said in the report overview. “Upside risks to inflation have thus increased, raising the prospect of higher for even longer interest rates, in the context of escalating trade tensions and increased policy uncertainty.”

Persistently high inflation means that the Federal Reserve’s much-anticipated rate cuts—which markets are convinced will begin in September—could be delayed.

Higher-for-longer interest rates, in turn, increase external, fiscal, and financial risks, raising the likelihood of a recession.

“We project global inflation will slow to 5.9 percent this year from 6.7 percent last year, broadly on track for a soft landing,” Mr. Gourinchas wrote. “But in some advanced economies, especially the United States, progress on disinflation has slowed, and risks are to the upside.”

The elevated upside inflation risk comes at a time when the U.S. economy is showing increasing signs of cooling, especially in the labor market, Mr. Gourinchas noted.

Clearer signs that the U.S. labor market is losing some steam came in the latest job creation report, which showed that government and health care services hiring made up about three-quarters of the payrolls gain and the unemployment rate hit a 2 1/2-year high of 4.1 percent.

Part of what’s driving up service wages is that goods prices remain high relative to services, making services comparatively cheaper and increasing their relative demand, Mr. Gourinchas wrote in the blog post. This, in turn, is putting upward pressure on services prices and wages.

“Indeed, services prices and wage inflation are the two main areas of concern when it comes to the disinflation path,” he wrote. “Unless goods inflation declines further, rising services prices and wages may keep overall inflation higher than desired.”

This situation alone, even without other factors such as excessive government spending and fracturing global trade crimping supply and pushing up goods prices, poses a “significant risk to the soft-landing scenario,” according to the IMF’s research director.

Excessive Spending, Deglobalization Risks

While the IMF doesn’t see any immediate market pressure on U.S. Treasury debt, it expressed longer-term concerns about the growth of U.S. debt and reliance on short-term financing.

“It is concerning that a country like the United States, at full employment, maintains a fiscal stance that pushes its debt-to-GDP ratio steadily higher, with risks to both the domestic and global economy,” Mr. Gourinchas wrote. “The increasing U.S. reliance on short-term funding is also worrisome.”

Higher debt, slower growth, and larger deficits increase the risk that government bond spreads push higher, with risks for financial stability.

“The exceptional recent performance of the United States is certainly impressive and a major driver of global growth, but it reflects strong demand factors as well, including a fiscal stance that is out of line with long-term fiscal sustainability,” the IMF wrote in the full report.

“This raises short-term risks to the disinflation process, as well as longer-term fiscal and financial stability risks for the global economy since it risks pushing up global funding costs.

“Something will have to give.”

As government debt pushes higher, this raises the risk of a sudden “disruptive” shift toward tax hikes and spending cuts, which the IMF says could weaken economic activity, erode consumer confidence, and sap support for fiscal restraint and other necessary reforms.

The IMF also warned of an intensification of deglobalization in the form of an increase in geoeconomic fragmentation. Increased barriers to the flow of goods, capital, and labor would imply a supply-side slowdown, which would be inflationary.

On the upside, the IMF says that looser fiscal policy could boost economic activity in the short term, although this would risk more costly policy adjustment at a later date.

Inflation could also fall faster than expected if there are further gains in labor force participation, which would give the Fed more leeway to start cutting rates sooner.

The IMF recommends that central banks take a balanced approach by neither cutting rates prematurely nor waiting too long and causing target undershoots.

When central banks finally do shift to less restrictive monetary policy, the IMF says, governments should reign in their spending to rebuild room for possible emergency deficit spending down the road, as well as to make sure that debt loads don’t become too burdensome and spark financial chaos.