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The Federal Reserve won’t sit idle if Congress fails to lift the debt ceiling and the government is unable to pay all its bills, economists said.
Treasury will have revenue coming in but not enough to cover all expenses — a technical default.
In order to understand what the central bank might do, Fed watchers are dusting off their copies of the minutes of a Fed meeting in October 2013, the last wide-ranging discussion of the topic among Fed officials that is publicly available.
At the start of the discussion, Former Fed Chairman Ben Bernanke said simply, “A default on U.S. Treasury securities would be a grave threat both to the economy and to the financial system.”
Economists agree, saying it is hard to overstate the difficulty for the U.S. economy created by hitting the debt ceiling.
Columbia University historian Adam Tooze says the U.S. Treasury debt market is now “too-big-to-fail” and more crucial to the national well-being than it was even a decade ago.
What’s puzzling to everyone is that this is a self-inflicted danger. Congress could quickly resolve the issue and raise or suspend the debt limit.
However, the political gains of having the public conclude that one political party is relatively more wasteful of taxpayer money seems such a tempting goal in today’s super-charged political environment that the crisis is upon us.
After Republicans in the Senate initially refused to cooperate with the Democrats to raise the federal debt ceiling, the Senate approved a $480 billion increase in the debt ceiling on Thursday, allowing for federal borrowing until Dec. 3, when funding for the federal government is also due to end again.
The House majority leader has promised a vote Tuesday on a bill raising the federal borrowing limit after the Senate acted late Thursday.
Analysts still expect cooler heads to prevail but they are going to the library for the Fed’s discussion of its emergency powers nonetheless.
Government officials are loath to even mention the plan exists for fear this could increase the risk of politicians causing a default, said Michael Gregory, deputy chief economist at BMO Capital Markets.
Gregory Daco, chief U.S. economist at Oxford Economics, said the economy would quickly stumble into a recession with massive job losses if Treasury cannot borrow.
The U.S. international standing, already damaged from the Jan. 6 insurrection at the Capitol, would once again be called into question, he said.
Daco noted that the Fed actions would essentially be a band-aide, only address the symptoms and not the root cause of the issues.
“The longer we would go beyond that drop-dead date, the more the stress would build and the more you’d risk seeing increasing pressures in various markets,” Daco said.
Treasury and the Fed would work closely to address the consequences. Treasury would prioritize payments with debt service at the top, Daco said.
Here are the Fed’s options to stem the spillovers to financial markets and prevent an excessive tightening of financial conditions, as laid out by Robert Perli, a former Fed staffer and now head of global policy at Cornerstone Macro.
The ideas are not the clever ones, like minting a trillion dollar coin, that have captivated social media.
Mild Fed options
First of all, the Fed could delay or even temporarily reverse its plans to slow down its $120 billion per month in asset purchases.
“This would be the most obvious thing to do,” Perli said.
The Fed would also provide loans to banks under its emergency window lending. Two other tools would be to use its new standing repo facility or its reverse repo program to ensure broad market stability.
Gregory noted that the Fed would allow banks to treat Treasurys as if they were not in default for meeting their capital ratios.
A more unusual step, Perli said, would be for the Fed to lend against technically defaulted Treasurys.
This would provide liquidity to the market and would “greatly diminish” the odds of a failed Treasury bill auction and dealers would always loan the bills to the Fed in return for cash regardless of whether they would default.
The ‘loathsome’ options
Perli notes that there is nothing in the law that would prevent the Fed from buying technically defaulted Treasurys. A similar idea would have the Fed swap good Treasurys on its balance sheet for technically defaulted ones. This idea was called “loathsome” by Fed Chairman Jerome Powell during the 2013 discussion. But other officials said the Fed couldn’t rule it out and Powell agreed.
“The Fed would not do this lightly because of the precedent, the perception that it would enable politicians to repeat debt ceiling standoffs in the future, and even the perception that the Fed would be directly financing an insolvent Treasury,” Perli noted.
The ‘nuclear’ option
Perli said the “nuclear option” that the Fed wouldn’t touch would be for the Fed to credit to Treasury any money needed for Treasury to operate normally. It would circumvent the debt ceiling but also circumvent Congress and the Fed would essentially become a fiscal authority.
“This would have worrisome consequences in terms of inflationary dynamics, central bank independence, and debt sustainability. You are traversing into an emerging markets world,” said Daco of Oxford Economics.
Creating money “out of thin air” would cause money to lose its value and accelerate inflation, and there are potential runs on debt with failed auctions. The U.S. dollar could fall sharply, he added
The yield on the 10-year Treasury note
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have moved above 1.5% this week.
