The financial system was able to avoid a massive collapse through the depths of the COVID-19 pandemic, but market participants are now telling the Federal Reserve that the Fed itself is now one of the biggest financial stability risks.
On Monday, the central bank released its semi-annual Financial Stability report, which shows “persistent inflation/monetary tightening” as the most cited potential shock over the next 12 to 18 months.
By comparison, a “sharp rise in real interest rates” and “inflation surge” were the second and third most cited shocks when the New York Fed conducted the same survey in May.
The concern: that the Fed may be too slow to respond to inflationary pressures, forcing the central bank to abruptly hit the brakes on its easy money policies. Doing so could create financial market turmoil as highly-valued risk assets reprice.
“Most contacts noted that the risk of sustained high inflation would likely be accompanied by monetary policy tightening, with potential effects on elevated risk-asset valuations,” the Fed report reads. “A few noted that a monetary policy response to stagflation risks would underpin a particularly sharp tightening of financial conditions.”
The Fed is currently clinging to its description of high inflation as “transitory,” emphasizing that a lot of the price increases being felt by consumers are due to supply issues linked to bottlenecks like limited microchip production and constrained ports.
As such, the Fed has signaled it will only gradually start to slow its pandemic-era monetary stimulus, beginning with a tapering of its asset purchase program this month.
But if inflation proves to be more deeply entrenched than the Fed imagined, the central bank’s hand could be tilted toward raising rates sooner and faster than the markets expect. The Fed is still holding short-term interest rates at near zero.
Risks from Evergrande
For now, the report broadly flagged asset valuations as “high compared with expected cash flows,” but noted that leverage at the nation’s banks “remained low.”
The report also flags a number of other risks, including new COVID variants and U.S.-China tensions that respondents have listed as concerns in previous surveys. But new factors also arose: notably leverage and regulatory risks in the Chinese real estate sector.
In the summer, concerns over the possible default of Chinese real estate conglomerate Evergrande raised questions about its risk to the global financial system.
“Several noted that the Chinese authorities appear willing to countenance more volatility than in the past as they pursue their deleveraging and regulatory goals, while worrying that officials could misjudge the scale of instability and contagion emanating from the campaign,” the report said.
For his part, Fed Chairman Jerome Powell had said that Evergrande remained an issue for Chinese officials to handle.
“In terms of the implications for us, there's not a lot of direct U.S. exposure,” Powell said on Sept. 22.
The report, however, said the risks in a globally connected financial system are never entirely contained.
“Given the size of China’s economy and financial system as well as its extensive trade linkages with the rest of the world, financial stresses in China could strain global financial markets through a deterioration of risk sentiment, pose risks to global economic growth, and affect the United States,” the report said.
Brian Cheung is a reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.
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