Inflation, potential large losses in real estate – both CRE and residential – seen as top ‘salient risks’ in Fed financial stability report

The impacts of persistent inflation, and potential large losses in real estate – both commercial and residential – are the two, top “salient risks” to financial stability most frequently cited by financial experts in a survey released late Friday by the Federal Reserve.

In its Financial Stability Report (FSR) issued late last week, the Fed said inflation (and the Fed Board’s response to it) and concerns over losses in real estate had risen, considerably, in the minds of its survey respondents. The report notes that last week’s survey found about three-quarters (72%) of respondents cited both “persistent inflation/monetary tightening” and “commercial and residential real estate” as salient risks to the financial system.

That’s up from the results of the May FSR, which found 56% and 52% of respondents, respectively, found those two areas to be leading risks.

“Contacts continued to highlight the risk of persistent or reaccelerating inflationary pressures, particularly in the U.S. amid a more resilient economic outlook, that could lead to further monetary policy tightening and volatile market conditions,” the report states. “Some contacts worried that persistent elevated inflation might entrench expectations of higher inflation, which could lead to higher realized inflation and require an even more restrictive monetary policy stance that could either induce or exacerbate a recession.”

As for real estate, respondents asserted in the survey that it is a “potential trigger” for systemic stress, most notably in the commercial sector. The FSR said concerns over higher interest rates, declining property prices, and structural shifts in demand for office space may prompt large realized losses.

“Survey respondents viewed small and regional domestic banks as particularly vulnerable due to their higher concentration of CRE (commercial real estate) exposures, which could lead to tighter bank lending conditions,” the report stated.

Other “salient risks” to financial stability highlighted in the report include reemergence of banking-sector stress (driven, in part, to potential losses on CRE exposures in smaller and regional banks and renewed deposit outflows, largely of uninsured deposits), market liquidity strains and volatility and weakness in the Chinese economy and financial sector.

“Contacts frequently noted slowing growth in China and highlighted several risks that could emerge from continued economic weakness, including capital flight, which could contribute to a stronger U.S. dollar and put downward pressure on Chinese assets and other Asian financial markets,” the report stated.

All three of the salient risks were cited the same or more frequently by the survey respondents in October compared to the previous survey five months ago. Banking-sector stress was cited by 56% of contacts surveyed (which was the same in May); market liquidity strains and volatility 56% (compared to 40%), and Chinese economy/financial sector weakness at 44% (compared to 12%).

The “salient risks” responses were generated from a Aug. 10 to Oct. 4 survey of 25 contacts, including professionals at broker-dealers, investment funds, research and advisory fi rms, and academics.

Financial Stability Report, October 2023