FX volatility set to rise as Central Banks step back from currency defense – IMF

Foreign exchange volatility is set to increase as central banks allow currencies to adjust to a fresh global shock driven by rising energy prices and geopolitical tensions, the International Monetary Fund (IMF) has said.

Speaking at the IMF/World Bank Spring Meetings in Washington D.C., Pierre-Olivier Gourinchas, the Fund’s Economic counsellor and director of Research, said policymakers are facing a classic negative supply shock that is already tightening financial conditions globally.

The shock, triggered by escalating tensions in the Middle East has pushed up oil and gas prices, alongside diesel, jet fuel, fertilizer, aluminum, and helium, raising production costs and weakening purchasing power across economies.

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Gourinchas noted that one of the key transmission channels is through financial markets, where higher risk premiums, falling asset prices, and a stronger US dollar are already creating pressure on currencies, particularly in emerging and developing economies.

“Financial conditions could tighten through lower asset valuations, higher risk premiums, capital outflows, and dollar appreciation, all of which would dampen demand,” he said.

In response, the IMF signaled that central banks should not rush to defend their currencies, but instead allow exchange rates to act as shock absorbers.

“In most cases, exchange rates should be allowed to adjust, allowing central banks to focus on their mandates,” Gourinchas said.

The guidance suggests a shift away from aggressive FX intervention, raising the prospect of sharper currency swings, especially in economies with weaker external buffers or high exposure to dollar-denominated debt.

Investors typically flock to safe-haven assets during periods of uncertainty, boosting demand for US Treasuries and strengthening the dollar. This dynamic, already evident in recent weeks, tends to trigger capital outflows from emerging markets, putting downward pressure on local currencies and tightening domestic financial conditions.

The IMF warned that such currency movements could feed into inflation, particularly in import-dependent economies, where weaker exchange rates raise the cost of fuel, food, and other essential goods.

Despite rising market expectations for higher interest rates, the Fund indicated that central banks can afford to take a cautious approach for now, provided inflation expectations remain anchored.

“Policymakers can wait and monitor developments, but they must remain vigilant and be ready to act decisively if risks to price stability emerge,” Gourinchas said.

The IMF outlined three scenarios in its latest outlook, all pointing to rising risks. Under its reference case, global growth slows to 3.1 percent in 2026 with inflation rising to 4.4 percent. In more adverse scenarios, tighter financial conditions and prolonged energy disruptions could push growth as low as 2 percent while inflation exceeds 6 percent.

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For central banks, the challenge lies in balancing competing pressures, managing inflation driven by external shocks while avoiding an excessive tightening of financial conditions that could undermine growth.

The Fund stressed that while monetary policy cannot directly influence global energy prices, it plays a critical role in preventing second-round effects such as wage-price spirals and unanchored inflation expectations.

If financial conditions deteriorate sharply, particularly under a severe scenario, the IMF said policymakers may need to pivot, deploying liquidity support and broader measures to safeguard financial stability.

As global risks intensify, the shift toward more flexible exchange rate regimes signals a new phase for currency markets, one where volatility, rather than stability, may become the norm.