Inflation taking toll on financial stability – as well as raising chance of economic slowdown, report contends

Inflation is elevating the threat to financial stability with “multiple indicators” signaling an upcoming economic slowdown, according to a report issued Thursday by the Treasury’s financial research arm.

According to the 2023 annual report of the Treasury’s Office of Financial Research (OFR), financial stability risks increased in 2023 and remained elevated. The report, which also reviews the performance of the OFR, said an economic slowdown could be magnified by the same factors threatening financial stability – inflation, geopolitical risks and global conflicts.

Among the key findings of the OFR report related to financial stability is that the commercial real estate (CRE) market in 2023 struggled with higher credit risks and difficult financial conditions due to decreased demand and lower valuation.

“Credit risks have built up in the CRE sector as borrowing rates have increased, pushing valuations significantly lower,” the report notes. “In particular, the office sector continues to face difficult financial conditions and struggles with weak demand, increased tenant vacancies, and declines in valuation following the rise of the work-from-home trend. Regional, smaller, and community banks are more exposed to CRE lending and, therefore, more vulnerable to increased default rates than the largest banks.”

The report lays some blame for heightened threat to financial stability at the feet of the Federal Reserve. The OFR report asserted that “Central Bank policies may have resulted in turbulence for the banking, funding, and real estate markets.”

“The monetary tightening policies begun in 2022 by the Federal Reserve may have created stressors for the banking, funding, and real estate markets in 2023,” the report states. “Many banks’ fixed-income securities portfolios showed large unrealized losses due to rising rates, which contributed to the demise of some of those banks,” referring to the failures of Silicon Valley Bank (SVB) of Santa Clara, Calif., Signature Bank of New York, N.Y., and First Republic Bank of San Francisco. The regional banks all failed in the spring.

“Following the regional banking crisis in the first half of 2023, banks’ balance sheets shrunk and lending to small, medium, and (to a lesser extent) large corporations declined,” the report states. “As mortgage rates reach their highest levels in 23 years, the inventory of homes for sale remains tight, pushing prices higher and contributing to the decline in home affordability.”

As for an economic downturn, the report acknowledges the recent robust labor market and sustained consumer spending has offset the probability of a recession in the U.S. in the near term.

However, the report states, the persistence of high inflation and interest rates has created “challenging conditions and raised the prospect of a recession in the medium term.”

“The policy posture of the Federal Reserve to manage core inflation by raising interest rates has increased borrowing costs for both companies and households, potentially dampening economic growth,” the report states. “Capital goods orders and shipments appear to have peaked through this year, with business capital investment falling as prices continue to rise. Higher prices for food, services, and shelter affected household balance sheets throughout the year and will likely result in diminished household savings and retail consumer spending. While the economy has proven to be resilient, forecasters have a dim outlook for GDP growth in 2024.”

OFR Finds Elevated Threats to U.S. Financial Stability Due to Inflation, Ongoing Geopolitical Risks, and Global Conflicts