(Bloomberg) — A Federal Reserve report flagged concerns about the risks of persistent inflation, the potential for large losses in the US office market and funding pressures on some banks.
The Financial Stability Report released Friday is the second since several banks failed following rapid interest-rate hikes. The collapses earlier this year led to weeks of wild trading in bank stocks and forced regulators to take the extraordinary step of protecting uninsured depositors at Signature Bank and Silicon Valley Bank.
The report, which isn’t a forecast, said deposit flows have since stabilized across the banking sector. “However, a subset of banks continued to face funding pressures, reflecting concerns over uninsured deposits and other factors,” the Fed said.
The central bank’s market, research and academic contacts signaled increasing concerns about inflationary pressures potentially leading to a more restrictive monetary policy stance — and the prospect of large losses in residential and commercial real estate. Three-fourths of survey participants highlighted those concerns, up from half of all participants in the May report.
Fed officials have raised interest rates by more than 5 percentage points since March 2022 and have signaled that they are inclined to hold policy steady for a second time in a row next month, after a recent run-up in bond yields tightened financial conditions.
The report focuses on four areas of risk.
Asset valuations: Equity prices climbed faster than expected earnings. Residential and commercial property prices remained high.
Borrowing by businesses and households: The Fed said household debt was at “modest levels” relative to gross domestic product and concentrated among prime-rated borrowers.
Leverage in the financial sector: The banking system remained sound and resilient, with risk-based capital ratios staying close to average levels in the past decade. However, high interest rates were depressing the fair value of longer-maturity, fixed-rate assets. Also, leverage was still high at the largest hedge funds.
Funding risks: Most US banks had stable funding and high levels of liquid assets. But some of them faced funding pressures, “reflecting concerns over uninsured deposits and other factors.”
The Fed, which measures a stable system by how well Wall Street can meet demand for financing even in the face of shocks, has raised interest rates at the fastest pace since former Chair Paul Volcker began his assault on inflation in the late 1970s.
The Fed was slow to forecast the pickup in price increases and rapidly accelerated its pace of tightening last year with four 75 basis-point hikes. Bond losses at regional banks began to raise questions about their stability. The Fed has further raised rates to a range of 5.25% to 5.5%.
In Friday’s report, the central bank pointed to risks to global economic activity — including sustained disruptions to regional trade in food, energy and other commodities — that stem from the Israel-Hamas conflict and the Russia-Ukraine war. It also highlighted concerns about the potential for slower economic growth in China.
“Given the size of its economy and financial system, financial stresses in China also could strain global markets more broadly through disruptions to economic activity, deterioration of risk sentiment, and possibly a sharp appreciation of the dollar, potentially affecting the US,” the Fed said.
—With assistance from Craig Torres.
(Updates with report’s geopolitical details in last two paragraphs.)