WASHINGTON—The Covid-19 pandemic remains one of the biggest near-term risks to the stability of the financial system, the Federal Reserve said, while noting that asset prices are vulnerable to significant declines if investor sentiment shifts.

“Should risk appetite decline from elevated levels, a range of asset prices could be vulnerable to large and sudden declines, which can lead to broader stress to the financial system,” the central bank said in its semiannual Financial Stability Report. Such scenarios could materialize if progress on containing the virus falls short of expectations or the recovery stalls, straining some households and firms, the Fed said.

The report said other parts of the financial system appear resilient. Banks remain well capitalized, it said, and leverage is low among broker-dealers. Household debt is manageable, and businesses are better able to service their obligations as interest rates remain low and earnings improve, it said.

High asset valuations were also flagged in the previous financial stability report, released in November. Thursday’s report showed measures of risk-taking have continued to rise in equity and bond markets since then. It also noted pockets of opaque risk and high leverage, particularly among hedge funds and related entities.

Fed Chairman

Jerome Powell

has described parts of the market, including equities, as “a bit frothy.”

“The overall financial-stability picture is mixed,” Mr. Powell said last week. “But on balance, you know, it’s manageable, I would say, and…it’s appropriate and important for financial conditions to remain accommodative, to support economic activity.”

At The Wall Street Journal’s CEO Council Summit, Janet Yellen expressed her confidence that the U.S. economy and employment will return to normal by next year.

Wall Street strategists and some investors argue that elevated stock valuations aren’t a problem as long as interest rates remain low and companies continue to report strong profit growth. But bullish investor sentiment has also played a role in keeping stocks moving higher, and a sudden change in their outlook would leave the market dangerously exposed to a pullback, said Mike Bailey, director of research at FBB Capital Partners.

Economists and Fed officials say the central bank’s efforts to boost the economic recovery have contributed to the run-up in asset prices.

The Fed has kept its key interest rate near zero since March 2020, making it cheaper for businesses and households to borrow and spend on things such as machinery, cars and homes. It also buys $120 billion worth of Treasury and mortgage backed securities each month, which holds down long-term interest rates and encourages investors to shift money into riskier assets such as stocks and corporate debt.

Mickey Levy,

an economist at Berenberg Capital Markets LLC, said the Fed knows its policies have unintended effects such as “distorting financial decisions, supporting high stock prices, accentuating wealth inequality and raising the risks of financial instability.”

“But the Fed perceives the near-term gains to employment exceed these costs and risks,” Mr. Levy said in a note to clients Wednesday.

Thursday’s report pointed to so-called “meme stocks” and the boom in initial public offerings supported by special-purpose acquisition companies, or SPACs, as evidence that investors’ appetite for risk “is elevated relative to history.” It also noted that yields on lower-rated corporate bonds have “declined significantly” over the past six months even as Treasury yields rose, indicating investors are accepting lower returns to take on risk.

Fed officials monitor asset prices to gauge risks that a sudden, sharp decline might pose to the broader financial system. In the 2008 crisis, the collapse of residential property values caused overextended homeowners to default on their mortgages, inflicting losses on banks and other financial firms, driving share prices lower and leading to the longest and deepest recession since the 1930s.

Last year’s downturn early in the Covid-19 pandemic was different. The longest economic expansion on record had put the average American household in relatively strong financial shape, and banks were well-capitalized as a result of regulations enacted after the 2008 crisis. As economic activity collapsed in March 2020, the government used its borrowing capacity to step in with trillions of dollars in aid to households and businesses.

“A decline in asset prices, home prices, cryptocurrency—would certainly hurt the people holding them,” said

Donald Kohn,

a former Fed governor. “But it’s not going to get amplified through weakness in banks and investment banks the way it did in 2007-2008.”

That doesn’t mean other sectors of the financial system, such as hedge funds, money-market funds and mutual funds that hold illiquid corporate bonds, are well positioned to weather a decline in asset prices, Mr. Kohn noted.

Thursday’s report also said the collapse of Archegos Capital Management, which caused more than $10 billion of unexpected losses at major banks, highlights “the need for greater transparency at hedge funds and other leveraged financial entities that can transmit stress to the financial system.”

While the Fed sees promoting a stable financial system as one of its key functions, it has few tools to prevent excessive risk-taking by investors aside from monetary policy—a blunt instrument that also affects workers, consumers and businesses.

So far, most Fed officials say they don’t believe lofty asset prices call for a reduction in the central bank’s asset purchases, let alone higher interest rates. One exception is Dallas Fed President

Robert Kaplan,

who said Thursday that the Fed should begin that debate as soon as it can.

“In light of some of the excesses and imbalances that can be created by these purchases, I think it’s wise and I think we would be well served to be talking about this subject sooner rather than later,” Mr. Kaplan said in a virtual event.

Write to Paul Kiernan at [email protected]

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