Powell backs rate hikes; says financial risks contained

Fed chairman Jay Powell

"Business sector debt relative to (gross domestic product) is historically high and there are signs of deteriorating credit standards", the Fed report stated. Unemployment is at a 48-year low, and inflation is right at the Fed's 2 percent target.

In prepared remarks for a speech at the Economic Club of New York, Chairman Powell said there is no "pre-set policy path", for interest rates, and focused on an economy that is "growing above trend".

Since stock prices have reached record highs over the past few years, they have a lot more room to fall, the report notes, stating that "elevated valuation pressures imply a greater possibility of outsized drops in asset prices". The companies taking out the most loans are the ones already in the most trouble.

Leveraged loans are most often packaged, or securitized, into so-called collateralized loan obligations, or CLOs. The Fed said the CLO market will be important to monitor. But over the past two years, this has changed. In an assessment of conditions in the banking system, the Federal Reserve said looming dangers meant asset prices could be in for a shock. It described funding risks in the financial system as low, meaning the chance that mispricing of one asset - in 2007, for example, housing - triggers a run by investors that puts the solvency of US banks at risk.

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The report also identified external risks, including potential spillover effects from Brexit and eurozone fiscal challenges, slowing-down growth in emerging market economies, trade tensions and geopolitical uncertainties, which could lead to "a decline in investor appetite for risks in general".

And heightened trade tensions might lead to financial turbulence in China that could spill over into the US, the Fed said.

For Wall Street, Wednesday's report could provide clues into the Fed's thinking on when it might use an obscure but powerful tool: the so-called counter-cyclical capital buffer, a mechanism that many countries have established to increase capital demands at big banks when a robust economy starts to show strain. But signs of a slowdown overseas and almost two months of market volatility - including a sharp selloff last week - have clouded an otherwise mostly rosy USA picture in which the economy is growing well above potential and unemployment is the lowest since the 1960s. The money would subsequently be released back to the banks when economic conditions deteriorated so that it would be available for lending. The authors define vulnerabilities as things that "build up over time and are the aspects of the financial system that are most expected to cause widespread problems in times of stress". Ordinarily, a member of the Fed's board, including the chairman, can not be removed from office by a sitting president other than for cause.

The report detailed four major risks factors to the stability of the economy: excessive leverage in the financial sector; funding risk, which refers to financial entities relying on sources of funding that can be rapidly withdrawn; excessive leverage in businesses and households; and overvaluation, known in extreme cases as a bubble.

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