Salient Risks to Financial System Rise: Insights from The Fed's Latest Financial Stability Report

The US economy remains on solid footing as the end of the year approaches, shrugging off earlier forecasts of a 2023 recession. However, the latest edition of The Fed’s Financial Stability Report depicts an increasingly complex risk landscape for the US financial system as we look towards 2024, driven by elevated inflation expectations, geopolitical uncertainty, and other salient risks.

The semi-annual survey reviews conditions affecting financial stability in five critical areas of focus—valuation pressures, borrowing by businesses and households, financial-sector leverage, funding risks, and near-term salient risks.

The first four categories reflect what Fed economists view as the primary cyclical vulnerabilities to the financial system at any given time. For example, household debt levels help us consider how the average American might fare if financial pressures increase, while bank liquidity levels give us clues about the financial system’s susceptibility to risky loans circulating in the market.

These four cyclical risks remain low by the Fed’s accounting. The current household debt to GDP ratio remains close to historical averages and continues to decline. In contrast, business debt has climbed but appears sustainable at current interest rates. Further, despite distress in the sector earlier this year, US banks remain highly liquid with capital ratios close to previous decade averages.

However, the fifth category, which considers emerging risks more salient to the current environment, appears to be rising. According to the results of its October survey, each of the five separate salient risks to the financial system that Fed researchers have identified in 2023 have either risen or remained unchanged relative to May.

Inflation and Real Estate Risks Remain

The two most present risks cited in the survey were the threats of persistent inflation and distress in the commercial real estate industry, each referenced by 72% of respondents. Curiously, inflation risk is increasingly cited despite the Fed having spent the past 20 months fighting it and evidence that price pressures have receded in recent months. However, the report crucially points out that geopolitical risk in energy markets remains a key factor and can lead to renewed cost pressures outside the Fed's scope of influence. Further, if energy prices remain stubborn, the Fed's monetary policy actions are constrained, limiting any potential for rate cuts in the near future. Luckily, energy prices have experienced a sharp decline in recent weeks, providing some breathing room for The Fed to consider the next steps.

Commercial real estate concerns also remain top-of-mind for respondents, primarily emanating from the risk that a slowdown in US growth could expose overleverage in the industry, leading to defaults and financial system contagion. The concern is directed mainly towards the struggling office sector, which has seen significant post-pandemic devaluation and could amount to pronounced losses among financial intermediaries in a worst-case scenario.

Global Risks Rise

The most significant jump is the risk posed by weakness in the Chinese economy. In May, just 12% of contacts surveyed cited weakness in the Chinese economy as a significant risk to the US financial system compared to 44% in October. Cascading strains in the world's second-largest economy, including a severe property sector downturn and a growing fiscal crisis among local governments, risks spilling over into global markets.

Geopolitical risks, mainly stemming from the Russia-Ukraine war and US-China relations, were decreasingly cited in the October results. However, the survey was conducted before the October 7th attacks on Israel and does not reflect the increased concern of a broader Middle East war since Israel began its operation in Gaza. The survey was also produced before President Biden's summit with Chinese President Xi, where both leaders emerged with a more diplomatic tone towards each other than in previous months. The report notes that rising geopolitical tensions could pose a risk to global economic activity, including disruptions to trade, food and energy supply, and risk appetite in the financial markets.

Looking Ahead

In the weeks since the Fed's report was released, several market-moving events have taken place that could realign risk evaluations to begin 2024. The most obvious is the October 7th attacks on Israel and subsequent war in Gaza, which has introduced a new geopolitical wildcard to an already jittery global marketplace. Domestically, slowing inflation and an averted US government shutdown have boosted market optimism, while a summit between US President Joe Biden and Chinese President Xi Jinping has renewed hopes of a diplomatic thaw between the two economic powerhouses. How these flashpoints develop alongside cyclical factors over the next few months will shape risk calculations heading into 2024.