Inflation and war in Ukraine seen as top risks to US financial system

High inflation, volatile stock and commodity markets and the war in Ukraine emerged as the top risks to the U.S. financial system, the Federal Reserve said Monday in a semiannual financial stability update that highlighted warns against a potentially “sudden” system. “disruption.

Rapidly rising US Treasury yields, war-related issues in oil markets and other factors have already strained parts of the financial system, the report warns, and while the stress “hasn’t been as extreme as in some past episodes, the risk of a sudden and significant deterioration appears higher than normal.

“It should be noted that households and businesses have decreased their borrowing as a percentage of gross domestic product and currently appear to have resources to cover the debt burden, which is an important aspect of resilience in a rising debt environment. interest rates,” the Fed Governor and Vice Chair-designate Lael Brainard said in a statement accompanying the report.

Monitors show breaking news about the Dow Jones Industrial Average on the floor of the New York Stock Exchange (NYSE) in Manhattan, New York, U.S., May 5, 2022. REUTERS/Andrew Kelly

The report is the first to take stock of the rapid changes in the financial landscape that have taken place since last fall, including a more rapid tightening of monetary policy by the Fed and a rise in interest rates in general, a inflation that threatens to become more persistent and The Russian invasion of Ukraine.

Volatility has played out in US stock markets which have fallen sharply in recent weeks as well as in bond markets which have adjusted to higher US interest rates and tougher financial conditions amid Fed efforts to slow inflation.

“Inflation has been higher and more persistent than expected, even before the invasion of Ukraine, and uncertainty about the inflation outlook poses risks to financial conditions and economic activity,” the report said. report.

Inflation and war in Ukraine seen as top risks to US financial system

The Federal Reserve Building is seen ahead of the Federal Reserve Board signaling its intention to raise interest rates in March as it focuses on tackling inflation in Washington, States United, January 26, 2022. REUTERS / Joshua Roberts

“Financial markets have experienced high volatility and stress on market liquidity,” over the past six months, the report said. “On the net, over the period, Treasury yields have risen markedly, broader equity prices have fallen significantly, and credit spreads have widened significantly in corporate bond markets.”

Since closing at a record high on the first trading day of 2022, the benchmark Standard & Poor’s 500 index has since slipped 16.5% and the Nasdaq Composite has fared even worse, losing more than a quarter. of its value in about six months. Yields on 10-year Treasury bills, influencing a range of consumer and business funding costs, have roughly doubled since the start of the year.

In a survey of economists and market participants on the main risks facing the US financial system, threats from the pandemic had faded and been replaced by a suddenly uncertain geopolitical environment.

Respondents to the survey, according to the report, were concerned that “strains in Europe related to the Russian invasion of Ukraine or in emerging markets – such as those that could stem from China or be driven by inflationary pressures – spread to the U.S. In addition, high inflation and rising rates in the U.S. could adversely affect domestic economic activity, asset prices, credit quality, and financial conditions in a significant way. more general.

Overall, corporate balance sheets remain healthy, with sufficient cash flow to cover interest payment obligations. But, according to the report, “the effect of high inflation, rising interest rates, supply chain disruptions and ongoing geopolitical conflict on corporate profitability is uncertain. A significant drop in corporate profitability or an unexpected increase in interest rates could reduce the ability of some companies to service their debt.

“In addition, upward pressure on oil prices, if sustained, could dampen the recovery in hard-hit industries such as airlines.”

(Reporting by Howard Schneider; Editing by Andrea Ricci)

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Don F. Davis