FOMC Minutes: "The staff provided an update on its assessment of the stability of the U.S. financial system and, on balance, continued to characterize the system's financial vulnerabilities as notable." Ruh-roh...

Fed Releases Minutes from July FOMC Meeting Highlighting Economic Concerns and Financial Vulnerabilities

The Federal Reserve released the minutes from the Federal Open Market Committee (FOMC) meeting held on July 30-31, 2024, providing insights into the economic and financial conditions discussed by the Committee. The minutes, published three weeks after the policy decision, reflect the information available at the time of the meeting.

Takeaways:

• The use of the ON RRP facility slightly declined during the intermeeting period. The Fed staff projected a more noticeable decline in ON RRP usage for the rest of the year, particularly with increased issuance of Treasury bills. However, specific idiosyncratic factors affecting some participants might sustain ON RRP balances.
• The Fed staff characterized the U.S. financial system's vulnerabilities as notable. Asset valuation pressures remained elevated, with risk premiums low compared to historical standards. House prices were still high relative to fundamentals, and commercial real estate (CRE) prices continued to decline, particularly in the multifamily and office sectors, where vacancy rates increased.
• Vulnerabilities related to business and household debt were seen as moderate. While nonfinancial business leverage was high, public firms' debt servicing remained solid due to strong earnings. However, the proportion of private firms with low debt-servicing capacity was rising. Household balance sheets remained robust, supported by high aggregate home equity and low mortgage delinquencies.
• Leverage in the financial sector was notable, with banking sector capital ratios remaining high despite low fair value of bank assets. Hedge fund leverage reached its highest level since 2013, driven by the cash–futures basis trade. Life insurers also showed elevated leverage and increased holdings of risky and illiquid securities.
• Funding risks were characterized as significant, with assets in prime money market funds and other cash-management vehicles near historical highs. Life insurers' reliance on nontraditional liabilities and risky corporate debt raised concerns about potential funding pressures in the event of adverse shocks.
• Risks to the inflation forecast remained tilted to the upside, though to a lesser degree than at the previous meeting.

"idiosyncratic factors specific to some ON RRP participants might support ON RRP balances in the months ahead."

What the staff is saying:

• Use of the overnight reverse repo (ON RRP) facility declined slightly over the intermeeting period. The staff projected that ON RRP usage would decline more noticeably over the remainder of the year, particularly as issuance of Treasury bills increases. However, the manager noted that it was possible that idiosyncratic factors specific to some ON RRP participants might support ON RRP balances in the months ahead.
• The staff provided an update on its assessment of the stability of the U.S. financial system and, on balance, continued to characterize the system's financial vulnerabilities as notable. The staff judged that asset valuation pressures remained elevated, with estimates of risk premiums across key markets low compared with historical standards. House prices remained elevated relative to fundamentals. CRE prices continued to decline, especially in the multifamily and office sectors, and vacancy rates in these sectors continued to increase.
• Vulnerabilities associated with business and household debt were characterized as moderate. Nonfinancial business leverage was high, but the ability of public firms to service their debt remained solid, in large part due to strong earnings. The fraction of private firms with low debt-servicing ability continued to move up and remained at high levels compared with the past decade. Household balance sheets remained strong overall, as aggregate home equity stayed quite high and delinquencies on mortgage loans remained low.
• Leverage in the financial sector was characterized as notable. Regulatory capital ratios in the banking sector remained high. The fair value of bank assets, however, remained low. For the nonbank sector, leverage at hedge funds was at its highest recorded level based on data since 2013, partly due to the prevalence of the cash–futures basis trade. Leverage at life insurers was somewhat elevated, and their holdings of risky and illiquid securities continued to grow.
• Funding risks were also characterized as notable. Assets in prime money market funds and other runnable cash-management vehicles remained near historical highs. Life insurers' greater reliance on nontraditional liabilities, coupled with their increasing holdings of risky corporate debt, suggested that adverse shocks to the industry could trigger substantial funding pressures at these firms.
• Risks to the inflation forecast were still seen as tilted to the upside, albeit to a smaller degree than at the time of the previous meeting.

For the nonbank sector, leverage at hedge funds was at its highest recorded level based on data since 2013, partly due to the prevalence of the cash–futures basis trade. Leverage at life insurers was somewhat elevated, and their holdings of risky and illiquid securities continued to grow.

What Participants are saying:

• As sources of upside risks to inflation, some participants cited the potential for disruptions to supply chains and a further deterioration in geopolitical conditions. A few participants noted that an easing of financial conditions could boost economic activity and present an upside risk to economic growth and inflation.
• In their discussion of financial stability, participants who commented noted vulnerabilities to the financial system that they assessed warranted monitoring.
• Some participants observed that the banking system was sound but noted risks associated with unrealized losses on securities, reliance on uninsured deposits, and interconnections with nonbank financial intermediaries.
  • In their discussion of bank funding, several participants commented that, because the discount window is an important liquidity backstop, the Federal Reserve should continue to improve the window's operational efficiency and to communicate effectively about the window's value.
• Participants generally noted that some banks and nonbank financial institutions likely have vulnerabilities associated with high CRE exposures through loan portfolios and holdings of CMBS.
• Most of these participants remarked that risks related to CRE exposures depend importantly on the property type and the local market conditions of the properties involved.
• A couple of participants noted concerns about asset valuation pressures in other markets as well.
• Many participants commented on cyber risks that could impair the operation of financial institutions, financial infrastructure, and, potentially, the overall economy.
• Many participants remarked that because a few firms play a substantial role in the provision of information technology services to the financial sector and because of the highly interconnected nature of some firms in the financial industry itself, there was an increased risk that significant cyber disruptions at a small number of key firms could have widespread effects.
• Several participants noted that leverage in the Treasury market remained a risk, that it would be important to monitor developments regarding Treasury market resilience amid the move to central clearing, or that it is valuable to communicate about the Federal Reserve's standing repo facility as a liquidity backstop.
• A couple of participants commented on the financial condition of low- and moderate-income households that have exhausted their savings and the importance of monitoring rising delinquency rates on credit cards and auto loans.

TLDRS:

• The Federal Reserve's July FOMC meeting minutes highlight economic concerns and financial vulnerabilities.
• Usage of the Overnight Reverse Repo (ON RRP) facility slightly declined, with a more noticeable decrease expected later in the year due to increased Treasury bill issuance but could change due to idiosyncratic factors specific to some ON RRP participants.
• The U.S. financial system's vulnerabilities were noted as significant by the staff, with elevated asset valuation pressures and low risk premiums; house prices remain high relative to fundamentals, while commercial real estate (CRE) prices continue to drop.
• Financial sector leverage is notable, with high banking sector capital ratios but low asset values; hedge fund leverage is at its highest since 2013, and life insurers are holding more risky and illiquid securities.
• Significant funding risks are present, with assets in prime money market funds at historical highs; life insurers' reliance on nontraditional liabilities and risky corporate debt raises concerns about potential funding pressures.
• Risks to the inflation forecast remain tilted to the upside, though less so than at the previous meeting.
• To fix one end of their mandate (price stability) from the inflation problem they created, the Fed will continue sacrificing employment (the other end of their mandate) to bolster price stability by continuing to hold or even increasing interest rates--causing further stress to businesses and households.
• I believe inflation is the match that has been lit that will light the fuse of our rocket.