The Federal Reserve announced on Thursday that the American banking system is projected to be able to weather the next recession.
The central bank’s stress test of major financial institutions involved a scenario in which unemployment rises up to 10% amid a decline in economic output. Because the banks have “strong capital levels,” they can “continue lending to households and businesses during a severe recession” — despite weathering $612 billion in predicted losses.
“The individual bank results from the stress test will factor directly into a bank’s capital requirements, mandating each bank to hold enough capital to survive a severe recession,” the Fed press release explained. “If a bank does not stay above its capital requirements, it is subject to automatic restrictions on capital distributions and discretionary bonus payments.”
In 2008, bank insolvency threatened to plunge the economy into a deeper recession, forcing the federal government to purchase toxic assets from investment banks through the $700 billion Emergency Economic Stabilization Act. The Fed began conducting its annual stress test in 2011 after the financial crisis.
The stress test comes as several economic phenomena — including record-breaking inflation — have eroded consumer and business confidence. The stock market has also endured weeks of heavy losses, with some analysts predicting that more falling asset prices are in the near future.
Earlier this week, Fed Chair Jerome Powell testified before members of the Senate that there is a “possibility” of recession.
“At the Fed, we understand the hardship high inflation is causing. We are strongly committed to bringing inflation back down, and we are moving expeditiously to do so,” the policymaker explained. “We have both the tools we need and the resolve it will take to restore price stability on behalf of American families and businesses. It is essential that we bring inflation down if we are to have a sustained period of strong labor market conditions that benefit all.”
Last week, the Fed increased interest rates by 0.75% — the largest rate hike increment since 1994. The central bank already hiked rates by 0.5% in May — the largest such increase since 2000 — after a 0.25% rate hike from near-zero levels in March. Interest rates are now at 1.5% to 1.75%, with more increases likely on the way.
Rate hikes are intended to cut inflation by increasing the cost of borrowing money — a move that tends to slow economic activity. Many investors, however, have nevertheless urged the Fed to tighten its monetary policy.
“The only way to stop today’s raging inflation is with aggressive monetary tightening or with a collapse in the economy,” Pershing Square Capital Management CEO Bill Ackman said last month. “There is no prospect for a material reduction in inflation unless the Fed aggressively raises rates, or the stock market crashes, catalyzing an economic collapse and demand destruction.”
Meanwhile, key policymakers have started to acknowledge that they failed to accurately predict soaring inflation. Treasury Secretary Janet Yellen admitted that she and Jerome Powell “could have used a better term than transitory” to describe higher prices.
“There’s no question that we have huge inflation pressures, that inflation is really our top economic problem at this point and that it’s critical that we address it,” she told Congress earlier this month. “I do expect inflation to remain high, although I very much hope that it will be coming down now.”