Federal Reserve warns of growing geopolitical risks to global financial system

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Escalating geopolitical tensions pose a threat to the global financial system amid heightened risks of higher inflation and slower growth, the Federal Reserve warned on Friday.

In its latest twice yearly Financial Stability Report, the US central bank flagged the potential for “broad adverse spillovers to global markets” in the event that the Middle East conflict and the war in Ukraine intensify or stresses emerge elsewhere.

“Escalation of these conflicts or a worsening in other geopolitical tensions could reduce economic activity and boost inflation worldwide, particularly in the event of prolonged disruptions to supply chains and interruptions in production,” the report said.

It added: “The global financial system could be affected by a pullback from risk-taking, declines in asset prices, and losses for exposed businesses and investors, including those in the US.”

The report — which stressed that the banking system on the whole remains “sound” and consumers and businesses have so far proven resilient in the face of higher interest rates — comes as Tel Aviv prepares for an expected ground offensive into Gaza following the attack on Israel by Hamas militants earlier this month. 

Jay Powell, the Fed chair, warned on Thursday that geopolitical tensions “pose important risks to global economic activity” and carry “highly uncertain” implications.

The Fed’s latest report also follows a sharp rise in global borrowing costs as financial markets have rapidly adjusted to reflect expectations that a resilient US economy is likely to keep the Fed’s policy rate at elevated levels for a sustained period of time.

Powell on Thursday suggested that an increased focus on the US debt burden may also be playing a role. According to figures from the Treasury department on Friday, the federal deficit has risen to $1.7tn, up from $1.37tn in 2022.

Borrowing costs globally have surged in recent weeks as Treasury yields of all maturities have risen sharply. The benchmark 10-year bond is now trading close to 5 per cent for the first time since 2007, while two-year yields hover at a 17-year high.

Since its previous report in May, the Fed found that Treasury market liquidity on the whole remained below historical levels, signalling that market participants are being “particularly cautious”. While businesses and households have digested higher interest rates with relative ease, the central bank noted that certain risky borrowers are beginning to feel more substantive strains.

The speed and magnitude of the recent rise in interest rates have stoked fears of brewing financial instability, with a top IMF official recently telling the Financial Times that there was now “heightened risk” of some kind of fallout.

In the event of inflation persisting unexpectedly, prompting central banks to have to raise rates further, the Fed warned of not only increased market volatility but also a “significant economic slowdown” as credit dries up and vulnerable households and businesses are forced to retrench.

A slowdown of that magnitude could pose a threat to the commercial real estate sector in particular, potentially leading to “significant losses for a range of financial institutions with sizeable exposures, including some regional and community banks and insurance companies”. 

Eventually, that could prompt certain lenders to pull back further, which “would further weigh on economic activity”, the report said. 

JPMorgan Chase chief executive Jamie Dimon last week warned that the current moment may be “the most dangerous time the world has seen in decades”. 

“Geopolitics, I think, is just an extraordinary issue we have to deal with,” he said. 

Banks have been cheered by losses and delinquencies so far not rising to elevated levels since the Fed started to raise its benchmark interest rate in its fight against inflation — a resiliency the central bank noted in its report.

However, Goldman Sachs chief executive David Solomon warned this week that “over the next two to four quarters, the impact of that tightening will be more evident and will create slowdowns in some areas”. 

“I am hearing, as I interact with CEOs, particularly around consumer businesses, some softness, particularly in the last eight weeks in certain consumer behaviours,” he said.