Fed flags oil shock, geopolitical risks as top stability threats in semi-annual report

The ongoing war with Iran and its shock to oil prices and supplies have rocketed to the top of the list of concerns for financial stability, according to the Federal Reserve’s semi-annual Financial Stability Report released on Friday.

Three-quarters of survey respondents cited geopolitical risks as a top concern, making it the most cited worry. The oil shock stemming from the Iran conflict was cited by 70 per cent of respondents. Artificial intelligence and private credit were both flagged as potential threats to financial stability by half of the survey participants.

What the report found

The report warned that a prolonged conflict in the Middle East, particularly if combined with shortages of commodities and impaired supply chains, could drive up inflation and slow economic growth in the US and elsewhere. Sharp price movements in energy markets and related financial products could lead to market strains.

Several respondents noted that inflationary pressure from the energy shock could force central banks to tighten monetary policy, even in the face of weaker economic growth. ‘Higher interest rates and inflation could have significant financial and economic effects, including declines in asset prices,’ the report warned.

The global benchmark crude oil price has shot up by more than 50 per cent since the US-Israeli strikes on Iran began on February 28 and it remains above $100 a barrel amid conflicting reports about whether a peace deal is near. An ‘oil shock’ appeared as the No. 2 concern in the latest Fed survey after not getting a single mention in the previous report last fall.

AI and private credit concerns

Survey respondents said there are concerns that AI investment is ‘increasingly funded’ by debt, which boosts broader leverage levels and increases fragility, and that the technology, if widely adopted, ‘may contribute to labor market weakness.’

The survey painted a mixed picture in the private credit sphere. It noted that the sector has grappled with negative sentiment and increasing redemption requests, but that so far the risks appear to be manageable. For the 10 largest perpetual business development companies in the sector, which account for roughly 80 per cent of private credit assets, there is enough bank credit and cash to cover at least three-quarters of redemptions, assuming they hold at a 5 per cent level, the report said.

The Fed said the risks to financial stability from private credit appear ‘limited and manageable,’ but noted that continued redemptions and negative sentiment could reduce credit availability for some borrowers, particularly those with higher credit risk.

What policymakers are saying

The concerns evident in the survey largely echo what many US monetary policymakers have voiced in recent weeks. The Fed left interest rates unchanged after its policy meeting last week, and more central bank officials in the days since then have said they cannot rule out potential rate hikes if inflation continues to rise and broaden out.

US gasoline prices have climbed to their highest levels since July 2022 and have led to a resurgence in inflation, now roughly a percentage point above the Fed’s 2 per cent target. Many US central bank officials worry that the longer those prices remain elevated, the greater the risk they spread beyond the energy complex and into a wider array of goods and services.