Board of Governors of the Federal Reserve System

Global growth has slowed and financial conditions abroad have generally tightened since the May Financial Stability Report, as economies continue to wrestle with the consequences of Russia's invasion of Ukraine, spillovers from China's containment of COVID-19 and its struggling property market, and stubbornly high inflation. Lower growth trajectories and rapidly rising interest rates as central banks respond to inflation have led to bouts of market volatility, and the dollar has appreciated significantly against most foreign currencies (figures A and B). This discussion describes several foreign risks that, if realized, could spill over into the United States, potentially affecting U.S. financial stability.

Figure A. 10-year government bond yields

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Note: The German yield is used for the euro area. The data extend through market close on October 20, 2022.

Source: Staff estimates based on data from Bloomberg Finance L.P.

Figure B. U.S. dollar versus currencies of selected economies

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Note: The data extend through market close on October 20, 2022.

Source: Staff estimates based on data from Bloomberg Finance L.P.

Continued or more extreme market volatility could contribute to liquidity strains that play out in unexpected ways.¹ Some financial institutions increased their use of leverage and derivatives during the long period of low and stable interest rates. With the recent sharp rise in the level and volatility of rates, these institutions can face strains. For example, beginning in late September, a sharp rise in U.K. government yields forced pension funds that had taken on leveraged interest-rate positions to liquidate assets to meet margin calls, pushing yields up further. This adverse feedback loop prompted the Bank of England to introduce a temporary bond purchase program to improve market functioning. More broadly, periods of market volatility may raise concerns about funding pressures for some financial institutions.

Russia's invasion of Ukraine continues to deliver a large adverse supply shock to the European economy that may pose challenges to the financial resilience of households, businesses, financial institutions, and governments across the region.² In late summer, Russia sharply reduced the flow of natural gas to Europe, further straining European energy markets and raising the possibility of some form of energy rationing to manage the supply shock. Higher energy costs could squeeze household budgets and could lead energy-intensive firms to cut production significantly. Additionally, many borrowers face rising interest payments. Taken together, these stresses could adversely affect European financial institutions.³ In addition, some European governments' fiscal positions could be stretched by a combination of weak revenues, higher refinancing rates, and the cost of support measures.

As U.S. monetary policy has tightened and concerns about global growth have risen, the broad real U.S. dollar index has strengthened to its highest level in over 30 years. Sharp movements in exchange rates may pose risks for institutions that are hedging dollar positions and to market functioning. The higher value of the dollar can increase stresses for any EMEs that have significant amounts of U.S. dollar debt that is neither hedged nor offset by dollar assets or revenues. This is because dollar appreciation increases the home-currency value of dollar debt, and the consequent increase in leverage may complicate the refinancing of maturing debt.

Global growth concerns amid rising interest rates in advanced economies have also led to significant portfolio outflows from EMEs. Additionally, trade disruptions and higher commodity prices have caused stress in some EMEs that are commodity importers. In some countries, droughts or floods have limited food supplies or hydroelectric production this year. Combined with higher commodity prices, this has increased concerns about food and energy security, creating new social and political tensions. These strains could further weaken the global outlook, and the financial transmission of these effects could be amplified by existing vulnerabilities in emerging markets, including levels of private-sector and government debt that have increased for many EMEs since the onset of the pandemic.

In China, stresses have persisted in the real estate sector, where activity and prices have been softening since last year.⁴ Along with disruptions to activity from the ongoing containment of COVID-19, the slowdown in property markets has contributed to exceptionally weak growth in China this year, prompting increased unemployment, capital outflows, and depreciation of the renminbi against the dollar. Very high levels of corporate debt, particularly in the real estate sector, may further amplify the strains that these developments could place on the Chinese economy and financial sector. Given China's size and its extensive trade linkages, a worsening of the current stresses in China could further depress activity and trade worldwide. Reduced Chinese import demand has already weighed on some other EMEs.

Disruptions to economic activity or financial markets abroad can affect the United States through several channels. A pullback in risk-taking worldwide may cause further declines in asset prices and tighter credit conditions abroad and in the United States. Some U.S. investors would incur losses on foreign exposures, and foreign financial institutions would likely reduce lending to U.S. businesses. Foreign investors could sell Treasury securities and other safe U.S. assets, potentially adversely affecting financial-market functioning and the transmission of monetary policy. Foreign official holders might sell reserves to defend home currencies, and private holders might sell Treasury securities in the context of a widespread surge in demand for dollar cash buffers.⁵ Broader pressure on large internationally active foreign banks could—if sufficiently severe—result in material spillover to U.S. financial stability through strains on dollar funding markets (in which foreign banks are large participants) and interconnectedness with U.S. banks, although the effects would be mitigated by the resilience and sound capitalization of the U.S. banking system.⁶ More generally, modern financial markets are interconnected, so stresses abroad could lead to strains in U.S. markets and challenges for U.S. financial institutions.

As highlighted in the November 2020 Financial Stability Report, the Federal Reserve is developing ways to monitor and assess financial risks that may arise from climate change. The Federal Reserve's responsibilities with respect to climate change are important but narrow. The Federal Reserve is committed to working within its existing mandates and authorities to promote a safe and stable financial system. The primary responsibility for addressing climate change itself rests with elected officials.

The unprecedented nature of climate change means that anticipating its potential effects on the safety and soundness of financial institutions and on financial stability requires forward-looking analyses. One such approach is climate scenario analysis. A climate scenario posits a potential future path of important climate-related factors, allowing analysts to explore the resulting effects on the economy and financial system. Different climate scenarios can embody different assumptions about how the future unfolds, thus helping illustrate how different risks may evolve and allowing an exploration of their potential implications. For example, in 2021, the European Central Bank conducted an exercise that assessed risks for companies and banks under three scenarios that varied in their levels of climate damages and in their transition paths to an economy that produces fewer greenhouse gas emissions.

To construct scenarios, analysts sometimes use economic models that can generate projected values for variables of interest—such as output, prices, and employment—that, in turn, affect the financial sector. Analysts can use climate scenarios to explore a wide range of implications in the financial sector for individual assets, companies, or industries, as well as for the overall macroeconomy. Some scenario analyses explore longer-run outcomes, such as how sea level rise might affect coastal property values over the life of a mortgage. Other analyses focus on shorter-run effects, such as the immediate effect of a change in climate policy on affected assets. Importantly, climate scenarios, as they are often used by financial regulators, are neither forecasts nor policy prescriptions in that they do not necessarily represent the most likely or desirable futures. Indeed, climate scenarios that are useful for risk analyses include ones that are relatively unlikely but could reveal potentially extreme downside outcomes that warrant thoughtful risk management.

For some risks, scenario analysis can offer advantages over simple risk metrics. For example, the economic and financial outcomes of greenhouse gas emissions abatement policies depend critically on the cost of reducing those emissions, which varies widely across different fuels, sectors, and sources and across different degrees of abatement. Policy outcomes also depend on how costs to regulated firms propagate through the economy to affect other firms, households, and the macroeconomy. Economic projections that incorporate these factors can highlight potential effects that might not otherwise be evident.

The Federal Reserve's climate scenario work includes assessing risks both to individual financial institutions and to the financial system more broadly. Next year, the Federal Reserve plans to engage with a small set of the largest bank holding companies to conduct a pilot supervisory climate scenario analysis exercise. This is distinct and separate from the Board's bank stress tests, which are designed to assess whether large banks have enough capital to continue lending to households and businesses during a severe recession. The Board's climate scenario analysis exercise is exploratory in nature and does not have capital consequences.

As part of its efforts to understand climate-related financial risks, the Federal Reserve is engaging with other central banks and authorities bilaterally and through participation in multilateral forums such as the Financial Stability Board and the Network of Central Banks and Supervisors for Greening the Financial System. The Federal Reserve is also learning from its counterparts around the world as they undertake exploratory climate-related supervisory exercises. The Federal Reserve is working closely with other U.S. financial regulators through the FSOC's Climate-related Financial Risk Committee. As its understanding about how to monitor and manage climate-related risks to the financial sector advances, the Federal Reserve will incorporate new findings into its financial stability work.

As part of its market intelligence gathering, staff from the Federal Reserve Bank of New York solicited views from a wide range of contacts on risks to U.S. financial stability. From late August to mid-October, the staff surveyed 26 contacts, including professionals at broker-dealers, investment funds, research and advisory organizations, and universities (figure A). Risks related to persistent inflation and tighter monetary policy, which were frequently cited in both the spring 2022 and fall 2021 surveys, remained top of mind (figure B). Respondents also continued to focus on a potential further escalation of Russia's invasion of Ukraine, especially as it relates to higher energy and other commodity prices and the economic outlook in Europe. A number of risks that ranked highly last spring fell in prominence, including concerns over risk asset valuations and the effects of COVID-19. This discussion summarizes the most cited risks in this round of outreach.

Figure A. Fall 2022: Most-cited potential risks over the next 12 to 18 months

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Note: Responses are to the following question: "Over the next 12–18 months, which shocks, if realized, do you think would have the greatest negative effect on the functioning of the U.S. financial system?"

Source: Federal Reserve Bank of New York survey of 26 market contacts from August to October.

Figure B. Spring 2022: Most-cited potential risks over the next 12 to 18 months

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Note: Responses are to the following question: "Over the next 12–18 months, which shocks, if realized, do you think would have the greatest negative effect on the functioning of the U.S. financial system?"

Source: Federal Reserve Bank of New York survey of 22 market contacts from January to April.

Persistent inflation and monetary tightening

Respondents remained concerned about the prospect of inflationary pressures being more persistent than anticipated, requiring a more restrictive monetary policy stance than reflected in market prices. Several contacts highlighted the global nature of monetary policy tightening and the potential for ­larger-than-anticipated effects on financial conditions as central banks adjust policy synchronously, especially given long and variable policy lags. Some contacts noted the risk that shrinking central bank balance sheets could prompt disruptions in funding markets or strains in market functioning. Meanwhile, a number of contacts expressed concern that central banks could pause tightening cycles or ease policy before inflation pressures are fully attenuated, leading to subsequent rounds of tightening that create volatile market conditions.

Geopolitical risks

Market participants continued to call attention to geopolitical risks, especially the possibility of a further escalation in Russia's invasion of Ukraine. In particular, many were attentive to the negative effects of the energy supply shock on net importers of natural gas—including higher inflation, lower growth, and weaker public finances. Some highlighted the deteriorating economic outlook in Europe as a result of the ongoing conflict, which could exacerbate fiscal deficits, create political instability, and spill over to the U.S. through trade, institutional, and financial market channels. Respondents also noted the risk of military or political conflict between China and Taiwan as well as any subsequent intervention by the United States, which would further disrupt global supply chains and weigh heavily on investor sentiment.

Market fragilities

Respondents highlighted a number of financial market developments that could pose risks to financial stability. Some pointed out that market liquidity, particularly in sovereign bond markets, remains challenged, noting that increases in net supply of debt securities from larger fiscal deficits and shrinking central bank balance sheets could lead to greater volatility. Several contacts saw potential spillovers from the scale and speed of the strengthening in the U.S. dollar, including the prospect of disorderly moves and potential actions by foreign authorities to manage exchange rates, either through intervention or unanticipated shifts in monetary policy.