By Pete Schroeder and Howard Schneider
WASHINGTON (Reuters) -Concerns over higher inflation and tighter monetary policy have become the top concern for market participants, pushing aside the COVID-19 pandemic, the Federal Reserve said on Monday in its latest report on financial stability.
At the same time, the semiannual report also flagged the growing use of stablecoins and "so-called meme stocks" as issues that merit attention and pose new types of potential risks to the financial system.
Roughly 70% of market participants surveyed by the Fed flagged inflation and tighter Fed policy as their top concern over the next 12 to 18 months, ahead of vaccine-resistant COVID-19 variants and a potential Chinese regulatory crackdown.
The Fed is struggling with inflation risk itself as it debates when interest rates may need to rise, and at this point investors expect the central bank will be forced to act sooner than policymakers themselves anticipate.
The focus on inflation marks a return, in a sense, to more normal concerns as the pandemic eases, and the Fed's report largely portrayed financial risks as well-contained.
"Fiscal and monetary policy accommodation, along with continued progress on vaccinations, continued to support a strong economic recovery," the report stated. "Despite the tragic human toll, the Delta variant has left a limited imprint on U.S. financial markets."
The Fed found that vulnerabilities in businesses and households were generally down, thanks in part to low interest rates and government support programs. Home prices were up broadly, but there was little sign of erosion in underwriting standards or speculative behavior.
While the overall credit quality of bank portfolios broadly improved in the last six months, the Fed noted delinquency rates for commercial real estate borrowers and other industries impacted by the pandemic remain elevated. It also flagged that leverage remained high for life insurance companies and hedge funds.
But the Fed did identify concerns, led by uncertainty over the course of the pandemic, degrees of government support, and the expected economic rebound.
"Uncertainty over the course of the pandemic and the expiration of relief programs may pose significant risks to household balance sheets," the report stated.
'MEME' STOCKS
In a first, the Fed devoted a section of its report to specifically explore the rapid, social media-driven volatility in some stocks like GameStop (NYSE:GME) and AMC Entertainment Holdings Inc.
While wild swings in their prices and other "meme" stock crazes have had a limited impact on financial stability, the Fed said the issue presents some potential concerns. For one, younger investors who flock to these companies tend to have higher household debt burdens, leaving them more vulnerable if asset prices crash.
In addition, the Fed said risk appetite among investors was at levels not seen since the "dot com" boom of 2001, but that conditions could change quickly, with volatility potentially supercharged by social media, should the pandemic worsen or economic recovery stall.
Risk management systems at financial institutions, the Fed said, may not be calibrated to account for the new high-risk investing approach to retail trading.
"A potentially destabilizing outcome could emerge if elevated risk appetite among retail investors retreats rapidly," the report noted.
The Fed also highlighted the growing use of "stablecoins," which are digital currencies whose value is supposed to be tied to a traditional currency like the U.S. dollar. The rapid adoption of these products has caught the attention of regulators, who worry they could be susceptible to runs and lack proper oversight.