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Why the Fed Is So Worried About the Debt-Limit Dispute Why the Fed Is So Worried About the Debt-Limit Dispute

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Economy

Why the Fed Is So Worried About the Debt-Limit Dispute

Federal Reserve Chairman Ben Bernanke has warned repeatedly about the fallout from a debt-ceiling breach. (Chet Susslin)

photo of Catherine Hollander
January 15, 2013

Federal Reserve Chairman Ben Bernanke is worried about the game of chicken that’s being played between the White House and Congress over the debt ceiling — and not only for the obvious reason that the stakes for the economy are huge and would affect the central bank's monetary-policy stance. Given its supervisory and operational role in financial markets, the Fed would also have a direct role in trying to contain the financial fallout if Congress misses the mid-February to early March deadline for raising the debt limit. So if Bernanke and his colleagues at the central bank are losing sleep over the next fiscal showdown, no one should blame them.

During the 2011 debt-ceiling fight, Bernanke was vocal about the risks of a default on the country's debt. He has spoken out about the upcoming struggle as well.

"It's very, very important that Congress takes the necessary action to raise the debt ceiling to avoid a situation where our government doesn't pay its bills,” Bernanke said Monday in an appearance at the University of Michigan’s Gerald R. Ford School of Public Policy.

 

Brian Smedley, an interest-rate strategist at Bank of America Merrill Lynch who previously worked as a trader and analyst at the New York Fed, walked National Journal through some of the problems the Fed would grapple with if Congress refused to raise the debt limit. (Smedley, as other economists do, cautioned that a U.S. default is "unprecedented" and it is impossible to predict the precise course of events that would unfold). Here's a look at the actions the Fed may have to take if brinksmanship turns into a stalemate—and a default:

  • Act as the nation's lender of last resort. If payments on government bonds are delayed, doubts would sink in about the ability of financial institutions to make good on their obligations in a timely manner. The Fed would then have to step in to provide short-term loans to banks to allow them to conduct their regular daily business.
  • Keep markets running smoothly. The Fed would likely step in if there was a disruption in the functioning of securities markets. If investors began selling off short-term government securities in the wake of a default, for example, the Fed could purchase Treasury securities, something it is already doing through its open-ended bond-buying program known to Wall Street as quantitative easing. (However, one Fed official, Philadelphia Fed President Charles Plosser, recently argued that the bank shouldn't use monetary policy to keep financial markets stable. It should instead rely on its supervisory and regulatory role for that end, he said.) 
  • Deploy its bank supervisors. The Fed supervises the country’s financial institutions and is responsible for monitoring their safety and soundness. With massive ripple effects through the financial system expected in the event of a default, the Fed would have to ensure that banks are positioned to manage that event.
  • Monitor risks abroad. Economists have warned about the global shock waves from a U.S. default. If the government had to stop payments in many areas, the result could be “a lasting increase in the risk premium on the world’s most important ‘risk-free’ financial asset—U.S. Treasury securities,” analysts at Deutsche Bank warned last week. The Fed, which has a number of roles in the international arena, would have to look at the international effects of default and the likelihood that the global turmoil would reinforce problems in the United States.
  • Adjust its monetary policy. The Fed conducts its monetary policy based on the health of the economy and its projected path. A default, with its disastrous economic effects, would likely spur the Fed to expand its current policies or to try new methods to rescue the economy. But it's not clear how much the bank could help. It has already cut short-term interest rates to zero. It has already announced open-ended quantitative easing. The Fed could expand its bond-buying program, but economists have warned that simply increasing QE might have diminishing returns. “Unfortunately, there’s very little the Fed could do if the government defaulted to offset that type of shock to the economy,” Smedley said. In other words, the bank might have to watch the recovery it’s been trying to help along take another huge hit.
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