WASHINGTON – The Federal Reserve Friday morning published its annual series of stress test scenarios, laying out in detail the three hypothetical sets of economic conditions that the largest U.S. banks will be expected to withstand when the stress tests are conducted later this year.

As in previous years, the Fed published three scenarios: one “baseline” scenario meant to represent a plausible forward trend without a severe economic shock event; an adverse scenario, which details an economic downturn; and a severely adverse scenario, which outlines an economic downturn on the order of the 2008 financial crisis. The scenarios are used to conduct the Fed’s Comprehensive Capital Analysis and Review stress test, as well as the Dodd-Frank Act stress test.

The baseline scenario tracks consensus projections detailed by the Blue Chip Economic Indicators published by consulting firm Wolters Kluwer last month, and suggests gradually declining unemployment and gradually increasing inflation to around 2.5% by the end of 2018.

Federal Reserve building.
The Federal Reserve published three scenarios to guide the 2017 stress tests: a "baseline" scenario, an "adverse" scenario and a "severely adverse" scenario. Bloomberg News

Under the adverse scenario, meanwhile, U.S. GDP drops to -1.5% in the first quarter of 2017 and bottoms out in the second quarter to -2.8% before emerging from recession in the second quarter of 2018 and rising to 3% a year later. Unemployment begins rising, starting at 5.2% in the first quarter of this year and peaking at 7.3% in the third quarter of 2018, while inflation remains low, peaking at only 2% in the second and third quarters of 2018.

The severely adverse scenario details a substantially deeper recession, with GDP dropping to -7.5% in the second quarter of 2017 and not emerging from negative territory until the third quarter of 2018 before rising to 3.9% in 2019. Unemployment peaks at 10% in the third quarter of 2018 and remains around 9% throughout the remainder of the scenario. Inflation remains well below 2% throughout the nine quarters outlined in the scenario.

One of the biggest differences between the 2017 severely adverse scenarios and those published for the 2016 stress test cycle is the absence of negative short-term Treasury rates – a feature not before included in stress tests. The Fed said the 2017 severely adverse scenario – which tends to be the binding constraint in the tests – “features a slightly more severe downturn” than was contemplated last year, with deeper recessions in the United Kingdom and the rest of Europe but lighter recessionary behavior in developing Asia.

This year’s stress tests also are notable because 21 of the 34 banks undergoing the tests will be exempted from the qualitative CCAR examination, where banks are not only assessed for whether their capital reserves remain above the regulatory minimum, but whether adequate systems are in place to ensure that the banks have a strong handle on their risk management capabilities. One additional bank, CIT, is undergoing the stress testing program in 2017 for the first time.

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