A shift in attention to geopolitical events this year could undermine the sustainability of the global upswing, warned Basel-based Bank for International Settlements.
The organization commonly known as the central bank of central banks said financial markets were confronted by a changing political environment as the economic background brightened.
"Political events surprised market participants, who quickly needed to take views on the shifting policy direction and its economic implications. Attention shifted away from monetary policy, and political events took center stage," the BIS said in its annual report published Sunday.
The report warns of four major risks - geopolitical ones aside - that could threaten the sustainability of the expansion in the medium term.
"First, a significant rise in inflation could choke the expansion by forcing central banks to tighten policy more than expected. This typical postwar scenario moved into focus last year, even in the absence of any evidence of a resurgence of inflation," the report warned.
Other risks include financial stress as financial cycles mature, weaker consumption and investment, mainly under the weight of debt and a rise in protectionism.
"A withdrawal into trade protectionism could spark financial strains and make higher inflation more likely. And the emergence of systemic financial strains yet again, or simply much slower growth, could heighten the protectionist threat beyond critical levels," the report warned.
Monetary policy highly accommodative
Leading Central banks took no time in pumping money into the economy following the global financial crisis of 2008 and the sovereign debt crisis in the euro zone. A number of institutions such as the European Central Bank and the U.S. Federal Reserve introduced bond-buying programs and cut benchmark rates in an effort to stimulate lending. A number of banks pushed interest rates into negative territory effectively charging banks who park cash at a central bank.
Interest rates across European central banks continue to remain at very low levels and in some cases below zero as economies scramble to push growth and inflation levels up. The BIS report, however, suggests that while inflation rates for the most part became better aligned with central bank price stability mandates, the significant reduction in labor market slack raised questions about upside inflation risks.
"An evaluation of those risks based on historical labor market developments suggests that they are unlikely to be the primary risk to the global expansion under way. Policy normalization presents unprecedented challenges, given the current high debt levels and unusual uncertainty," the report said.
US dollar in focus
The report outlines that while the financial sector has improved, the environment is still challenging. The near-term outlook, however, has brightened substantially but the attention on U.S. dollar will remain a likely pressure point during episodes of market stress.
"Banks' continued heavy reliance on short-term U.S. dollar funding, paired with a high degree of market concentration and interconnectedness, underscores the importance of supervisory cooperation and effective backstops. The ultimate aim is a stronger financial system that helps support the resilience of the global economy," the report said.
On global economy, the BIS remains upbeat and says the economy has strengthened further, growth has approached long-term averages, unemployment rates have fallen towards pre-crisis levels and inflation rates have edged closer to central bank objectives.