Peter Schiff Slams Fed's Stress Tests: 'They Know No Major Bank Could Survive Stagflation'

Economist and investment broker Peter Schiff has criticized the Federal Reserve's annual stress test scenarios, arguing that they fail to account for the potential impact of stagflation on banks' balance sheets and profitability. In a recent interview, Schiff stated, "Yesterday the Fed released its bank stress tests. In the ‘Severely Adverse Scenario,’ the Fed assumes a recession with a sharp decline in interest rates and inflation. They did not test a scenario where there is a recession, but interest rates and inflation rise." Schiff believes that the Fed's plan for stagflation is to hope it doesn't happen, as no major bank could survive it.

The Federal Reserve's 2025 stress test scenarios, released on February 5, outline hypothetical economic conditions designed to evaluate the resilience of major U.S. banks. The tests include a baseline scenario reflecting expected economic trends and a severely adverse scenario simulating a deep recession, significant asset price declines, and increased market volatility. However, Schiff argues that the Fed's assumptions behind the test are flawed, as they do not account for the possibility of stagflation – a combination of high inflation and high unemployment.

In the severely adverse scenario, the U.S. unemployment rate is projected to rise from 4.1% in late 2024 to a peak of 10% by the third quarter of 2026. The scenario also anticipates a sharp economic downturn, with a 7.8% decline in real GDP, a 33% drop in house prices, and a 30% fall in commercial real estate values. Additionally, the global market shock component subjects banks with significant trading activity to extreme financial stress, while the counterparty default component examines the impact of a major counterparty failure.

Schiff's criticism highlights a concern that the Fed may not be adequately preparing for a stagflation scenario, in which both inflation and interest rates rise while economic growth declines. In such an environment, banks would face significant challenges, including increased defaults on loans, reduced lending capacity, and lower net interest margins. The Fed's stress tests do not explicitly account for these risks, potentially leaving banks ill-prepared for a stagflationary environment.

To better assess banks' resilience to stagflation, the Fed's stress tests could be adapted in several ways. Incorporating stagflation-specific assumptions, adjusting interest rate assumptions, examining the impact on bank funding costs, evaluating the impact on loan portfolios, assessing the impact on bank capital, considering the impact on bank liquidity, and evaluating the impact on bank profitability could all help to provide a more comprehensive evaluation of banks' ability to lend to households and businesses in adverse economic conditions.

In conclusion, Peter Schiff's criticism of the Fed's stress tests highlights the importance of considering the potential impact of stagflation on banks' balance sheets and profitability. By adapting the stress tests to better account for this risk, the Fed can help ensure that banks are better prepared to navigate adverse economic conditions and continue lending to households and businesses in times of economic distress.