WASHINGTON – Large banks will simulate their ability to weather both deflation and a recession among the annual economic scenarios provided by the Federal Reserve Board on Thursday for the central bank's 2016 stress tests.
As part of its stress test regime, the Fed releases hypothetical scenarios of varying degrees to assess the strength of banks with over $50 billion in assets. This year's scenarios will feature deflation as part of the "adverse scenario," and a major worldwide recession as the "severely adverse scenario."
"For the 2016 cycle, the severely adverse scenario is characterized by a severe global recession in which the U.S. unemployment rate rises five percentage points to 10 percent, accompanied by a heightened period of corporate financial stress and negative yields for short-term U.S. Treasury securities," the Fed said in a press release accompanying the scenarios. "The adverse scenario features a moderate recession and mild deflation in the United States, as well as weakening economic activity across all countries included in the scenario."
The Fed's stress tests include the Dodd-Frank Act Stress Test (known as DFAST) and the more intensive Comprehensive Capital Analysis and Review (known as CCAR). DFAST examines the performance of each bank's portfolio under a generic capital management plan, while CCAR examines the portfolio's performance under the bank's own capital management plan. Both tests examine the banks' performance over the course of nine future quarters and under three hypothetical macroeconomic scenarios of varying adversity. (One of the scenarios is usually just a standard or "baseline" economic environment.)
The tests are meant to determine on an annual basis whether the largest U.S. banks have adequate capital reserves to withstand realistic and appropriately adverse economic stress conditions – conditions like those that took the global economy by surprise in the 2008 financial crisis. But the Fed repeatedly noted in its release that those scenarios are purely hypothetical and not forecasts or predictions.
The Fed's baseline scenario for the 2016 stress tests includes gradually but mildly improving economic conditions, with GDP growing at a brisk 2.5%, increasing Treasury yields and inflation rising to 2.5% by the middle of 2017. The Fed noted that the baseline scenario is similar to that predicted by the January 2016 Blue Chip Economic Indicators report and the International Monetary Fund's October 2015 World Economic Outlook report.
The adverse scenario, by contrast, features moderate recession in Europe and Japan and below-trend growth in China. Unemployment rises to 7.5% in the U.S. by the middle of 2017, interest rates remain "near zero" and consumer prices fall by 0.5% over the course of 2016. The Fed said the 2016 adverse scenario differs from the 2015 adverse scenario in the inclusion of the drop in consumer prices, or deflation.
The Fed's severely adverse scenario, meanwhile, is more severe than the one contemplated in the 2015. The new severely adverse scenario includes a deeper global recession, with U.S. GDP falling dramatically, unemployment reaching 10% by mid-2017, "subdued" inflation and a sharp drop in asset prices.