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Fed Does Not Work Miracles, But It Has An Emergency Manual

The crisis management manual created by the Federal Reserve experts years ago is key to finding the possible response of the central bank to a potential default in the payment of the US federal debt. Time is running out, while Republicans and Democrats do not finish approaching positions to raise or suspend the debt ceiling in the US.

If the federal government cannot meet its financial obligations, the Fed will try to prevent the fire from spreading, while acknowledging that it will not have enough water to suffocate it on its own. The damage to markets and the economy will be severe.

Among the tools available, the Fed could buy bonds and Treasury bills that would enter the ‘red zone’ of the defalult (default) and sell other Treasuries with different maturities and coupon payment dates to counteract potentially severe tensions in the financial markets, according to the transcript of an October 2013 conference call . The Fed only publishes transcripts of these types of events five years after they have occurred.

Among the officials who argued that those steps should not be ruled out were Jerome Powell , the current central bank chairman, who was then only a member of the FOMC, and Janet Yellen, the current Treasury secretary, who was then a Fed vice chair.

However, the members of the Fed themselves hinted at that time that these measures are undesirable. Now, the US Government is approaching the abyss and, probably, the members of the FOMC and the Fed, in general, consider these measures just as undesirable, but under its mandate there could be this extreme possibility of ‘altering’ the market (buying bonds with very high risk of partial default) to avoid that a financial shock ends up weighing down employment, one of the pillars of his mandate.

In that 2013 telephone conversation, where these types of borderline decisions were addressed, it was confessed that it would be taken if necessary, but to do so would be very “unpleasant”. In the first place, it would be a form of quasi-direct financing to the government, breaking the independence of fiscal and monetary policy . Second, Fed officials were concerned that if such contingency planning were made public, politicians could delay negotiations on the debt ceiling, knowing that the Fed would be a last resort to ‘save’ the Treasury.

Institutional risk
“These are decisions that you really, really, never want to have to make,” Powell said on the call. “The institutional risk would be enormous. The decision for the economy is correct, but you would be entering this difficult political world and it would seem that you are making the problem disappear.”

Other members who shared that view were Boston Fed Chairman Eric Rosengren and then San Francisco Fed Chairman John Williams, who is now New York Fed Chairman.

The debt ceiling in the US
The US is once again immersed in another political showdown over how to raise the debt ceiling before the Treasury Department is unable to pay interest and some spending in the coming months. This is how the debt ceiling works step by step.

Lawmakers agreed in August 2019 to suspend the borrowing limit for two years. This cap went into effect again last month, with current debt of about $ 28.5 trillion, far exceeding the $ 22 trillion ceiling. Right now, the Government is managing payments thanks to the significant liquidity reserves that it accumulates in the Fed and that still exceed 300,000 million dollars, as explained from The Wall Street Journal .

The market does not believe it
The markets remain calm because although this time it seems different, the limit has been raised or modified 98 times despite constant disagreements. Congress and the president have never allowed the US to stop paying its obligations.

However, this time it seems really difficult that the bill to suspend the debt ceiling is approved in the Senate, where the forces are very balanced.

This tension can be seen in the environment. Jerome Powell refused last week during a press conference to give details about the Fed’s contingency plans, but warned of severe damage to the economy and financial markets if Congress waits too long to act. “It’s just not something we should contemplate,” he said. “No one should assume that the Fed or anyone else can fully protect the markets or the economy in the event of a failure.”

In 2011, Standard & Poors, for example, lowered the US credit rating from triple-A to double-A when Congress came close to not extending the ceiling. This downgrading of the credit rating increased the Treasury’s borrowing costs by about $ 1.3 billion that year , according to the Government Accountability Office, amid rising interest rates.

On both occasions, the FOMC and the Fed’s team of experts discussed behind closed doors what they would do if the stagnation led to the government defaulting on debt payments or further instability in the financial market, according to transcripts released five years later.

Powell, at the time, warned Republicans about the consequences of non-compliance, who used it as a lever to seek spending cuts from President Barack Obama. The now Fed chairman was then an analyst at the Washington think tank called the Bipartisan Policy Center.

After that confrontation was resolved and the debt ceiling increased, Obama’s advisers recommended Powell’s nomination to the Fed’s board of governors, and it was confirmed in 2012. Later, under the presidency of Donald Trump, Powell became chairman of the Fed in 2018.

Last week, the economic policy director of that think tank, Shai Akabas, published projections showing the Treasury could run out of money between October 15 and November 4. Friday, October 15, could be a particularly difficult date for federal finances because there is a large payment owed to a veterans retirement pension fund to take on. Financial and economic risks could accelerate from that point, according to the expert.

Extraordinary measures
Fed officials already created in 2011 a process to manage government payments that would allow the Treasury to prioritize the payment of principal and interest on public debt over other obligations, transcripts show.

Furthermore, they are also prepared to communicate to banks that they can count treasury bills in default for their regulatory capital reserves and that they would not penalize banks facing a fall in capital reserves. This would ease the selling pressure on the US debt, containing the financial costs for the Treasury.

On the other hand, the Fed would be willing to flood the markets with liquidity in exchange for Treasuries, albeit at potentially reduced market prices, provided it is certain that the government will pay the principal quickly after the ceiling is raised. Of the debt.

There are also special measures that could flood the loan markets with cash, including through the provision of very short-term loans between financial institutions called repurchase agreements (repo) , which could also alleviate pressures on monetary funds and other mutual funds. . Despite all this emergency arsenal, if there is no agreement, the recovery will be in jeopardy.

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