The Federal Reserve's latest Financial Stability Report highlights a marked shift in the threat landscape for the financial system, with survey respondents elevating geopolitical tensions - particularly the ongoing war with Iran - and an accompanying oil shock to the top of their list of concerns.
According to the semi-annual survey summarized in the report, three-quarters of respondents identified geopolitical risks as a top concern, while 70% cited the oil shock arising from the war as a primary worry. Artificial intelligence and private credit also emerged as material issues, each flagged by about half of those surveyed.
Inflation and growth risks tied to the Middle East conflict
The Fed report warns that a prolonged conflict in the Middle East - particularly if it coincides with commodity shortages and disrupted supply chains - could push inflation higher and slow economic growth in the United States and abroad. The report further notes that sharp moves in energy prices and related financial instruments could create strains in markets.
Several respondents expressed concern that inflationary pressure stemming from the energy shock might force central banks into tighter policy settings even as economic growth weakens. The report succinctly captures this connection: "Higher interest rates and inflation could have significant financial and economic effects, including declines in asset prices."
Those worries align with recent commentary from many U.S. monetary policymakers. The Fed left interest rates unchanged after its policy meeting last week, and officials in the days since have cautioned that a further broadening of inflation could not be ruled out, leaving potential rate hikes on the table.
Magnitude of the oil shock and consumer impacts
The document places the oil shock squarely among the foremost financial stability risks. The global benchmark crude price has risen by more than 50% since U.S.-Israeli attacks on Iran began on February 28, and it remains above $100 per barrel amid conflicting signals about the prospects for a peace settlement. U.S. gasoline prices have climbed to their highest levels since July 2022 and have contributed to a resurgence in inflation, which the report indicates is roughly a percentage point above the Fed's 2% target.
The report emphasizes that the longer elevated energy prices persist, the greater the chance they spread beyond the energy sector into a broader range of goods and services, intensifying inflationary pressures and complicating central bank responses.
AI and private credit: rising but different kinds of risk
Respondents to the Fed survey also drew attention to risks related to artificial intelligence. The report states concerns that AI investment is "increasingly funded" by debt, which could raise leverage in the system and heighten fragility. Additionally, respondents warned that widespread adoption of AI "may contribute to labor market weakness."
Private credit presented a mixed picture in the survey. The report notes the sector has experienced negative sentiment and heightened redemption requests, but that, to date, those pressures appear manageable. For the 10 largest perpetual business development companies in the sector - which account for roughly 80% of private credit assets - there appears to be sufficient bank credit and cash to cover at least three-quarters of redemptions, assuming redemptions run at a 5% level, the Fed said.
While the Fed judged risks from private credit as "limited and manageable" at present, it warned that ongoing redemptions and persistent negative sentiment could curtail credit availability for certain borrowers, particularly those with higher credit risk.
Implications for markets and policy
The confluence of elevated energy prices, geopolitical uncertainty and rising concerns about technologically driven leverage means policymakers and market participants face a set of interacting risks. The report underscores how energy-driven inflation could prompt policy tightening that, combined with higher rates and inflation, might depress asset valuations. At the same time, the evolving profiles of AI-related investment and private credit exposures suggest areas where leverage and liquidity stresses could materialize.
In sum, the Fed's semi-annual assessment portrays a financial-stability environment where geopolitical and commodity shocks have jumped to the forefront, while newer vulnerabilities tied to AI and private credit merit continued monitoring.