Fed cites inflation, monetary policy as top financial stability concerns

As inflation continues to run at 40-year highs in the U.S., financial markets are worried both about rising prices and the Federal Reserve's monetary response to them. 

In the Fed's latest financial stability report, published Friday afternoon, persistent inflation and monetary tightening were identified as top concerns among 62% of broker-dealers, investment funds, research and advisory organizations, and academics surveyed by the Federal Reserve Bank of New York.

Some respondents cited the compounding effect of interest rates being raised by central banks around the world simultaneously and the potential liquidity restraints from the reduction of the Fed's balance sheet as specific concerns. Others worried the Fed would reduce its tightening efforts too soon.

Bloomberg News

Russia's invasion of Ukraine also remains a substantial concern for financial stability, the New York Fed found, with an equal number of market participants counting it among their top concerns for the smooth functioning of financial markets.

Also, market liquidity strains and volatility, which were not cited at all during the prior report, were mentioned in more than half the responses in this month's report, with respondents pointing to the Fed's balance sheet reduction as a possible strain on liquidity.

Fed Vice Chair Lael Brainard, who has already raised concerns about the potential spillover effect of global monetary tightening, said the volatility seen in financial markets during the past six months has highlighted the need for tracking vulnerabilities. 

"Today's environment of rapid synchronous global monetary policy tightening, elevated inflation, and high uncertainty associated with the pandemic and the war raises the risk that a shock could lead to the amplification of vulnerabilities, for instance due to strained liquidity in core financial markets or hidden leverage," Brainard said in a statement. "It's important to remain attentive to the risks raised in the report and to work with domestic and international regulators to support the resilience of the financial system."

This month's report comes on the tails of the Fed's fourth 75-basis-point interest rate increase of the year, which was implemented after this week's Federal Open Market Committee meeting. 

It also arrives amid growing concerns from economists and lawmakers that the Fed has raised its benchmark interest rate too high too quickly, battering the U.S. housing market and destabilizing other global economies that are heavily dependent on the dollar. Before this week's FOMC meeting, more than a dozen members of Congress urged the Fed to slow its pace of tightening or pause altogether to allow the impact of the increases implemented already to be fully absorbed by the economy.

Some have been waving a caution flag about the Fed moving too quickly since its first 75 basis point increase in June.

This week, Fed Chair Jerome Powell brushed off those concerns, noting that he would rather risk overtightening than undertightening. Should the Fed go too far, he explained, it could always loosen monetary policy again to offset the negative effects. 

"It's premature to discuss pausing and it's not something that we're thinking about," Powell said Wednesday in his post-FOMC press conference. That's really not a conversation to be had. We have a ways to go,"

While this month's financial stability report highlighted potential vulnerabilities and several exogenous factors to watch out for, its overall assessment of financial stability during the past six months was fairly positive.

Powell waves off financial stability concerns after another big rate hike

"Over the period, household and business indebtedness has remained generally stable, and on aggregate households and businesses have maintained the ability to cover debt servicing, despite rising interest rates," Brainard said.

Areas of vulnerability include asset prices, where home and commercial real estate values remain elevated. Also, use of leverage by hedge funds and other nonbanks is on the rise. 

Short-term funding was identified as another area to monitor, as key markets — such as bond and bank-loan mutual funds — remain subject to unexpected withdrawals. 

Concerns about the war in Ukraine appear to have diminished since the Fed's last stability report, released in May, when 77% of those surveyed cited it as a concern for the coming 12 to 18 months, a decrease of 15 percentage points. Inflation and monetary policy concerns were also cited less in this month's report, down 6 percentage points from the spring report.

Meanwhile, concerns about a Chinese invasion of Taiwan in the next year or so were up significantly, going from 14% of respondents citing it May versus 42% in November.