Rising tensions in the Middle East are now seen as a bigger short-term threat to the US financial system than persistent inflation and high interest rates, according to the Federal Reserve’s latest financial stability report, released on Friday.
The report revealed that 46% of respondents identified Middle East tensions as a key risk to financial stability, surpassing concerns about inflation and monetary tightening, which were cited by 33%. This marks a notable shift, as inflation risks were previously flagged by 72% of respondents in the Fed’s earlier report, showing a significant decline.
Key Risks and Concerns
The financial stability report, a biannual assessment by the Federal Reserve, tracks potential threats to the US financial system. The latest report showed a 14% increase in those worried about Middle East tensions. Fiscal debt sustainability topped the risk list, with 54% of respondents viewing it as a critical concern.
Respondents noted that the most immediate danger from Middle East tensions is the risk of a broader regional conflict, potentially escalating into a global issue. The main financial impacts would stem from disruptions to energy supplies and commodity markets, which are key channels affecting stability.
Geopolitical Risks in Focus
Geopolitical risks, including the ongoing wars in Ukraine and the Middle East, have become a regular part of the Federal Open Market Committee’s discussions. The report warned that further escalation of these tensions could slow economic activity, drive higher inflation, and increase volatility in global financial markets.
The combination of high asset valuation pressures and growing geopolitical uncertainties raises the risk of a sudden shift away from risk-taking, which could reduce asset prices and expose businesses and investors to financial vulnerabilities.
Fed’s Perspective on Current Economic Outlook
Fed Chair Jerome Powell referred to elevated geopolitical risks as looming “black clouds.” While these conflicts have had minimal economic impact so far, Powell highlighted the potential for rapid change, particularly if oil prices spike. However, oil prices have been relatively stable recently, with Brent crude closing at $71.20 per barrel and West Texas Intermediate at $71.16 per barrel on Friday.
Despite these risks, the US economy remains strong. Supported by robust consumer spending, the economy grew by 2.8% last quarter, while unemployment remains low at 4.1%, and inflation is nearing the Fed’s target of 2%.
Expectations for a Soft Landing
The improved inflation outlook has raised hopes for a “soft landing” scenario. The Fed, which has lowered interest rates by 75 basis points since September, will decide in December whether further policy adjustments are needed. Positive trends in inflation and monetary policy were reflected in the survey, with those citing inflation as a primary risk dropping by 59%.
However, 38% of respondents still view a recession as a potential threat, reflecting lingering uncertainty. Concerns about a global trade war are also growing, as respondents highlighted risks from protectionist policies and retaliatory tariffs, which could disrupt global trade flows and pressure inflation upward.
Market Trends and Banking Resilience
The report noted that the 10-year Treasury yields have risen despite the Fed’s rate cuts, reflecting ongoing market concerns. While household and business debt vulnerabilities have eased, credit card and auto loan delinquencies remain above pre-pandemic levels.
The US banking system continues to show resilience, but funding risks are still considered notable, even though they have declined slightly.
