Ben Bernanke has spent half of a decade trying to coax investors out of their postrecession bunkers. Now, Congress is set to send them running for cover again.
The government may not default on its loans in the coming weeks, but just by coming close to the edge, lawmakers will pull markets in the exact opposite direction from where the Federal Reserve has been trying to push them.
Bernanke's bid to resuscitate the economy depends on persuading people to make two leaps of faith. First, businesses require enough confidence in the future to ask for the big loans they need to expand their operations, in part by hiring some of the country's 11.3 million unemployed workers. Second, lenders need to believe that making those loans is the best use of their money.
The Fed's quest to drive down interest rates targets both goals. By keeping rates low, Bernanke makes it cheaper for borrowers to take out loans. And to persuade lenders to take a risk on those loans, the Fed has bought up massive quantities of Treasury bonds—considered the ultimate safe investment—in an effort to drive down the rate at which those bonds pay off to private investors. The hope is that investors, dissatisfied with the low rate of return they get from the federal government, will instead put their money into the private sector.
That's where Congress's behavior is so damaging. By precipitating one crisis after another, lawmakers are sending investors running back to investments like Treasury bonds—which keep their money safe but do precious little in the way of stimulus. If Congress wanted to spook lenders, it could hardly pick a better method than flirting with default. "It would be the opposite of what the Fed's wanted to do," says Stuart Hoffman, chief economist at PNC Financial Services. "It basically says something has happened outside the Fed's control that could shock the economy into recession."
For Bernanke, the current debt-ceiling standoff may be all the more infuriating because he's seen it, and its destructive effects, play out before. When the country last brushed up against the debt ceiling in the summer of 2011, investors flocked to Treasury bonds, looking for a safe place to park their assets while they waited to see whether Congress was going to unleash economic chaos.
As investors sought refuge in bonds, they fled from stocks. The stock market—facing a default threat in the U.S. and a sovereign-debt crisis in Europe—plunged as the Aug. 2 debt-ceiling deadline approached and congressional Republicans, Democrats, and President Obama remained deadlocked. The Dow Jones industrial average began sliding on July 22, and the losses weren't erased until January of this year. A government default was averted in the nick of time, but Standard & Poor's cut the country's AAA credit rating.
History appears poised to repeat itself as bond interest rates are falling sharply in the run-up to the new deadline, Oct. 17. The yield on the 10-year Treasury bond, the market's benchmark, hit a two-month low on Oct. 3, signaling that investors are willing to swallow lower payouts on their investment in exchange for safe harbor. Yields on the one-month T-bill soared Tuesday; the higher short-term federal borrowing costs reflected investors' concerns about a default in the coming weeks. Stocks have slipped in recent weeks, too, as a government shutdown stretches on and the borrowing-limit deadline nears.
On the face of it, it's confusing that investors would seek refuge with the U.S. government at the same time the government is in danger of defaulting on its debts. But investors figure Washington will eventually meet those obligations, and that in the turmoil accompanying a brush with default—or if the country's credit rating is lowered—other investments would fare worse.
"Treasuries are worth a little less [after a downgrade]," Hoffman says. "And guess what? Everybody else is also worth a little less."
The Fed may already be responding to the uncertainty of today's government shutdown and potential default. Bernanke was expected to announce the beginning of a dialing-back in Fed stimulus in September, but his policy-making committee shocked investors by announcing the Fed would keep going full speed ahead and obliquely referencing Washington's fiscal turmoil as one of the causes for the decision.
It's unclear how much leverage they have left. The Fed has already bought more than a trillion dollars worth of bonds and has kept the federal funds rate, the central bank's benchmark interest rate, close to zero for more than four years—and none of that has managed to move the unemployment rate down to 6.5 percent, the point at which the Fed said it would begin to slow down its stimulus efforts. Bernanke has said the stimulus programs could offer "diminishing returns" over time.
There are also risks in the Fed's responding to fiscal chaos by buying more bonds and keeping interest rates low. Federal Reserve Board Governor Governor Jeremy Stein has warned that a prolonged low-rate environment could cause investors to "reach for yield," Fedspeak for investors who seek profit so desperately that they pile into the riskiest investments and imperil the entire financial system. And Kansas City Fed President Esther George has voted against the Fed's stimulus efforts this year, citing concerns about creating "financial imbalances."
But for now, with unemployment still high, and with a generation of workers watching as the prolonged economic slump damages their long-term economic prospects, Bernanke's bigger worry is that all his efforts have failed to produce the good-times-are-here-again growth that Americans are waiting for.
Throughout his tenure, Bernanke has spoken optimistically about the Fed's power to heal a damaged economy, but barring a dramatic course correction, the chairman will spend his final few months watching Congress break it all over again. Maybe Janet Yellen, whom the White House nominated Wednesday to succeed him, will have better luck with Capitol Hill.