Favourable global economic prospects, particularly strong momentum in the euro area and in emerging markets led by China and India, continue to serve as a strong foundation for global financial stability.” This statement opened the International Monetary Fund’s April 2007 Global Financial Stability Report. Since this benign view was published on the eve of the most devastating financial crisis in nearly eight decades, it has to be viewed, in hindsight, as a spectacular misjudgment. The fund is determined not to be caught out again. The question is whether the concerns it pours forth in its latest Global Financial Stability Report are well judged or whether it is crying wolf. As important, what might be the implications, especially for policy, of its worries?

The underlying argument of the report is that “near-term risks to financial stability continue to decline”, but “medium-term vulnerabilities are rising”. The return of global economic growth, combined with comfortable monetary and financial conditions, together with sluggish inflation, strengthens investors’ reach for yield and appetite for risk. With market and credit risk premiums at decade-low levels, asset valuations are vulnerable to a “decompression” of risk premiums — in blunter words, a crash.

As the report notes, shocks to credit and financial markets well within the historical range could have large negative impacts on the world economy: “A sudden uncoiling of compressed risk premiums, declines in asset prices, and rises in volatility would lead to a global financial downturn.” Many hold the room for monetary policy manoeuvre to be limited. The result might then be a less deep, but still more intractable, global recession than that of 2009.