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Fed outlines potential risks for U.S. economy in first financial stability report

Federal Reserve Chairman Jerome Powell

The Federal Reserve, in its first financial stability report, said Wednesday that trade disputes, uncertainties surrounding Brexit and slowing Chinese and emerging markets could disrupt the U.S. economy, which already is seeing "elevated" asset prices.

Valuation pressures are "generally elevated," as investors appear "to exhibit a high tolerance for risk-taking," particularly with respect to assets linked to business debt, such as high-yield bonds and leveraged loans, the report said.

Moreover, "debt owed by businesses relative to gross domestic product is historically high, and there are signs of deteriorating credit standards," the report added.

With respect to trade, geopolitical uncertainty and other adverse shocks, the Fed said each could yield a decline in investor appetite for risks, which could lead to a large drop in asset prices "given that valuations appear elevated relative to historical levels."

While a deal for the U.K. to leave the European Union has yet to be finalized, the implications of Brexit could lead to "market volatility and a sharp pullback of investors and financial institutions from riskier assets," the Fed report said.

And if significant problems arise in China, such as an escalation in international trade disputes or a collapse in real estate prices, it could strain the repayment capacity of Chinese borrowers and financial intermediaries, the report stated. If China and emerging markets more broadly experience significant problems, "spillovers, including dollar appreciation, declines in world trade and commodity prices, and a pullback from risk-taking by investors outside the affected markets, could be sizable," the Fed said.

Even the Fed's policy of gradually raising interest rates could negatively impact the economy. "Markets and institutions that may have become accustomed to the very low interest-rate environment of the post-crisis period will also need to continue to adjust to monetary policy normalization by the Federal Reserve and other central banks," the report said. "Even if central bank policies are fully anticipated by the public, some adjustments could occur abruptly, contributing to volatility in domestic and international financial markets and strains in institutions."

In a speech Wednesday before the Economic Club of New York, Fed Chairman Jerome Powell said the economic effects of gradual rate increases are uncertain, and might take a year or more to be fully realized.

The Fed has raised rates three times in 2018 and could do it once more at its next meeting Dec. 18-19. "While (Federal Open Market Committee) participants' projections are based on our best assessments of the outlook, there is no preset policy path," Mr. Powell said. "We will be paying very close attention to what incoming economic and financial data are telling us. As always, our decisions on monetary policy will be designed to keep the economy on track in light of the changing outlook for jobs and inflation."

But the report, which the Fed plans to publish semiannually moving forward, also signaled areas where the economy is on stable footing. Borrowing by households has risen roughly in line with household incomes, the nation's largest banks are strongly capitalized and leverage of broker-dealers is substantially below pre-crisis levels, the report said.

The report did not come to a bottom-line conclusion, but Mr. Powell said that while "risks are above normal in some areas and below normal in others, overall financial stability vulnerabilities are at a moderate level."