Financial markets remain fragile and a negative feedback loop between markets and the global economy appears to be materializing, warns Jaime Caruana, director of the International Monetary Funds’s Monetary and Capital Markets Department.

At a news conference today, Caruana said that while financial markets “have made significant adjustments”, global financial markets remain fragile and indicators of systemic risks remain elevated. He added that the downside risks outlined in the IMF’s latest stability report in April “appear to be materializing, leading to a negative feedback loop between the financial system and the broader economy.”

Building inflationary pressures are complicating this interaction, he added. “As economies slow credit deterioration is widening and deepening, and as banks deleverage and rebuild capital, lending is beginning to be squeezed, restricting household spending and clouding the outlook for the real economy,” he noted.

“Stemming the decline in the U.S housing market would remove a key component of the feedback loop, as this would both help households and financial institutions recover. At the moment, however, with delinquencies and foreclosures rising sharply and house prices continuing to fall, a bottom for the housing market is not yet visible and the credit deterioration is spreading to even prime mortgage loans. House prices are also now softening in a number of other European economies, prompting concerns over future loan losses in the mortgage, construction, and commercial property sectors in those countries,” Caruana noted.

On the positive side, he pointed out that banks have generally been successful in raising capital and balance sheets are adjusting. “The adjustment process by financial institutions is necessary, and must continue, even if it is expensive and difficult. Moreover, as economic growth slows, banks will face continued headwinds in maintaining earnings due to falling credit quality, declining fee income, high funding costs, and exposures to ‘monoline’ and mortgage insurers. Consequently, bank share prices have fallen sharply and measures of credit default risk have risen,” he noted.

“With continuing pressures on financial institutions to deleverage, assets are being sold, lending conditions are being tightened and their capacity to provide credit might slow further,” Caruana added. “One positive development, however, has been the continuing resilience of investment grade bond issuance, indicating healthy corporates still have access to needed funds. At the same time, however, the scope for monetary policy to be supportive of financial stability appears to be more constrained than before amid high and volatile commodity prices that have raised inflationary risks.”

Emerging markets have remained resilient to the credit turmoil, Caruana said, but the financial crisis and the inflation threat are starting to present a more serious test to this resilience, he said. “Some emerging markets are coming under increased investor scrutiny, especially those with large external imbalances and inflation risks.”

“It is important to recognize the complexity in dealing with these inflationary pressures, especially set against a slowing global economy and the need to respond on different fronts. But it is also important to insure that the benefits achieved over years of good macroeconomic policies are not put at risk. If inflationary expectations become entrenched, not only might sharper tightening of monetary conditions be necessary, but financial markets and flows may also be sensitive to situations in which policies are perceived to be ‘behind-the-curve’,” he said.

Amid the deleveraging process and uncertainty about asset valuations, credit risks remain elevated, Caruana said, “indicating that further raising of capital may be needed in a number of financial institutions.” This raises questions about the extent and nature of government support, he said, adding, “Financial market disruptions will still need to be dealt with on a case-by-case basis and there is no iron-clad rule-book as to how to handle such instances in today’s more global environment. Prompt and transparent government responses, however, will go a long way to relieving the uncertainties.”