By Tom Fairless and Jon Hilsenrath
SINTRA, Portugal -- European Central Bank President Mario Draghi urged central banks to better coordinate policies to confront the problem of ultralow inflation in an era of slow global growth, underscoring the conundrum he and his associates face in the wake of Britain's vote to leave the European Union.
The guardians of the global monetary system face conflicting pressures as they seek to support their economies amid new turbulence. They also run the risk that their efforts will work at odds with each other and destabilize the financial system.
Central banks should examine whether their policies are "properly aligned," Mr. Draghi said at an ECB conference in Portugal. He further warned that currency devaluations aimed at boosting national competitiveness are a "lose-lose" for the global economy.
"In a globalized world, the global policy mix matters -- and will likely matter more as our economies become more integrated," Mr. Draghi said. "The speed with which monetary policy can achieve domestic goals inevitably becomes more dependent on others."
His warning resonated as central banks try to respond to the looming Brexit. Last week's vote sent currencies spinning, pushing up the dollar and Japanese yen and driving down the euro and the British pound. It also sent investors away from stocks and risky bond investments. Markets settled on Tuesday after two days of sharp selling of risky assets.
The Bank of England faces the risk of recession paired with the threat of inflation. If it lowers interest rates to boost growth, it could put additional downward pressure on its currency which stirs inflation. If it stands still, economic growth could suffer.
The Federal Reserve, meantime, had been expecting to raise interest rates this year. If it acts now it could put sharp upward pressure on the dollar, hurting U.S. exporters and emerging market economies with large exposures to U.S. dollar debt. The Fed is likely to shift to a "wait and see" mind-set in the short-term to assess the fallout of the British vote.
The Bank of Japan, seeking to relieve upward pressure on its currency, could launch new easing efforts as early as next month. But its last attempt -- an experiment with negative interest rates -- backfired.
Mr. Draghi's remarks indicated a "definite shift" in his own thinking, said Frederik Ducrozet, senior economist with Banque Pictet & CIE SA in Geneva. "It suggests that the ECB is increasingly concerned about those 'global factors' driving inflation that they cannot directly influence."
Investors are increasingly concerned that the central bank is running out of tools to support the eurozone economy and drive up inflation.
"I think the ECB does not have a lot of ammunition left, at least a lot that would really make a difference," said Martin Lück, chief German investment strategist at BlackRock, Inc., which manages assets worth $4.7 trillion.
Mr. Draghi spoke of "persistent headwinds" from abroad that have forced central banks to use their policy tools with ever more intensity, resulting in "higher financial stability risks and spillovers to economic and financial conditions in other jurisdictions."
He cut short his appearance at the conference in Portugal to attend an EU summit in Brussels. There, he told European leaders that he expects the U.K.'s decision to reduce economic growth in the eurozone by a cumulative 0.3% to 0.5% over three years, people familiar with the matter said.
Mr. Draghi said the estimate is provisionary and in line with private-sector estimates, they added. In forecasts published this month, the ECB predicted that the eurozone's economy would grow by 1.7% in both 2017 and 2018.
The economic hit is the result of the U.K.'s importance as a major trading partner, and a possible perception that the EU could become ungovernable, the people said.
Mr. Draghi and other central bankers have been calling on politicians to use fiscal policy and structural changes to their economies to spur growth. However few developed countries have much room to cut taxes or boost spending in the wake of the 2007-2009 financial crisis.
Reaching consensus on other issues -- such as immigration or business regulation -- has proven difficult in an environment of political tumult in the U.S. and elsewhere.
Against this backdrop, the Fed is effectively at a standstill. Officials want to see how the British vote plays out before making any move on rates. That takes an interest-rate increase off the table at their next meeting July 26-27.
To raise rates at their following meeting Sept. 20-21, they would need to see markets settle, along with clear evidence U.S. economic growth, hiring and inflation are on upward paths.
Fed officials in December raised their benchmark short-term rate to a range between 0.25% and 0.5% and penciled in four quarter-percentage-point interest rate increases in 2016. They revised that down in March to two moves and now it isn't clear if they'll get even one.
Traders on the Chicago Mercantile Exchange see a 15% probability the Fed will raise rates one time by December and an 8% probability the central bank will cut rates back to near zero.
Stocks rebounded Tuesday after two days of sharp selling and remain up from their February lows. The dollar, though it strengthened after the vote, remains 5% below its January highs, which is supportive of U.S. exports.
Still, U.S. growth has been soft, corporate profits are down, and hiring has slowed, which left Fed officials wary of the outlook even before the British vote.
"I don't think you start from a particularly strong position," said Lewis Alexander, chief U.S. economist at Nomura Securities. He sees the Fed raising short-term rates once in 2016 and once in 2017, but no more.
A slow-moving Fed could help ease pressures on financial markets around the world, particularly in emerging markets, which are highly exposed to upward movements in the dollar.
The Bank for International Settlements calculates borrowers in emerging markets are exposed to $3.3 trillion in dollar-denominated bond market debt, which becomes more expensive to pay off when the dollar appreciates.
A slow-moving Fed could also make it easier for major central banks, particularly the Bank of England, to pursue new easing measures without spurring major dislocations in their currencies.
Meanwhile, the Fed is contributing to efforts to ensure the global financial system is flush with dollar credit to safeguard against market instability.
Japan's central bank said it would draw almost $1.5 billion from Fed swap lines which make dollars available to other large central banks. It was the largest amount in 1 1/2 years, as Brexit-induced financial turbulence increases demand for the world's dominant trading currency.
Financial companies participating in the latest weekly auction asked for $1.48 billion in total, the largest amount since Dec. 24, 2014, according to the central bank.
The degree of demand was still nowhere near the levels reached in the wake of the failure of Lehman Brothers in September 2008, suggesting that markets haven't entered a crisis stage. The latest amount compares with between $15 billion and $50 billion provided by the BOJ at each operation between September and December 2008.
Japanese banks typically tap into BOJ operations when they have trouble raising dollars themselves. The same operations in previous weeks had each attracted only about $1 million to $2 million in requests from financial firms.
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