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Explainer-From 'loathsome' to routine, Fed has a well-rehearsed debt-limit playbook

Economy Feb 03, 2023 06:12AM ET
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© Reuters. FILE PHOTO: An eagle tops the U.S. Federal Reserve building's facade in Washington, July 31, 2013. REUTERS/Jonathan Ernst

By Howard Schneider

WASHINGTON (Reuters) - Federal Reserve Chair Jerome Powell was blunt this week when he said the central bank couldn't shield the economy from the damage should the current standoff over the federal debt ceiling trigger a U.S. debt default later this year.

The U.S. government neared its $31.4 trillion debt ceiling earlier this month, prompting the Treasury Department to warn that it may not be able to stave off default past early June. Republican U.S. House of Representatives Speaker Kevin McCarthy said on Thursday that he and President Joe Biden have agreed to meet again for talks on raising the U.S. government borrowing limit.

When asked about the matter at a news conference after the end of the U.S. central bank's latest policy meeting on Wednesday, Powell declined to say whether Fed officials had begun planning for a possible default.

Even if the central bank could not prevent the worst, the Fed would have a role in providing liquidity to financial firms and markets roiled by any failure of the U.S. government to meet its obligations, and the likely playbook officials would follow was captured in transcripts of planning sessions held during previous fiscal showdowns in 2011 and 2013.

Those measures include routine steps the Fed already takes daily to grease the country's key financial markets, as well as some less conventional measures - "loathsome" was the word Powell used to describe some of the options during a 2013 debt limit discussion when he was still a relatively new member of the Fed's Board of Governors - that might come into play depending on how bad things get.

Here are some of the Fed's options:


The U.S. central bank's basic responses to debt-limit-related market stress were laid out in an August 2011 conference call held by its policy-setting Federal Open Market Committee to discuss what seemed to be imminent trouble.

Two of the key ideas described back then, the use of repurchase and reverse repurchase agreements to ensure liquidity for the most important financial markets, have since been turned into permanent programs by the Fed and are integral to how it manages interest rates on a day-to-day basis.

If market stress became apparent in short-term interest rates, it would be a simple matter to temporarily increase the amounts available for "repos," agreements that amount to short-term sales or purchases of securities that can run into the trillions of dollars each day. Indeed, doing so might be necessary for the Fed to conduct monetary policy if market stress pushed the target federal funds rate - the benchmark overnight interest rate - above or below the range set by the central bank.

"If there were pressures pushing the funds rate higher the (Fed market desk) would automatically add reserves to deal with that," William English, a Yale School of Management professor, said in a recent interview. As head of the Fed's monetary affairs division at the time, it was English who briefed officials in 2011 on possible options.

The Fed's most standard tool, lending money to banks through its discount window, would also be available.


Another quick tool at hand would be to suspend the current "quantitative tightening," also known as QT, used by the Fed to shrink its balance sheet each month, said Roberto Perli, head of global policy at Piper Sandler. As it happens, Perli on Thursday was named by the New York Fed as its chief for open market operations, the unit that oversees the U.S. central bank's portfolio of assets. His comments preceded the appointment.

While QT is part of the Fed's move to tighten monetary policy to control inflation, it has a net effect of pulling about $95 billion a month out of financial markets - money the central bank could in effect add back by holding its balance sheet constant until the debt-ceiling standoff ended.


A default would not extend to the nearly $24 trillion stockpile of Treasury securities all at once - it would spread one bill, one note, one bond at a time as interest and principal payments became due.

A step English said the Fed could take to limit the damage without much legal or political peril would be for it to accept any defaulted Treasury securities as collateral for its standing programs.

The securities would be discounted to a market price. But a default presumably would be viewed as temporary, so the securities would hold much of their value.

Letting institutions still use those securities for repos, discount window loans, or other Fed programs "seems appropriate so long as the default reflects a political impasse and not any underlying inability of the United States to meet its obligations, so that all payments on defaulted securities would presumably be made after a short delay," English told officials, according to a transcript of the 2011 conference call. The approach "appeared acceptable" to Fed officials previously, and was included in a draft statement the central bank had prepared in the event a debt limit compromise was not reached.


The next and most sensitive steps for the Fed would involve removing defaulted securities from the market altogether - either through outright purchases that would involve increasing its balance sheet, or "swaps" in which it would trade its own holdings of Treasuries on which interest or principal payments were expected to stay current for those that were in default.

Either one, by effectively trying to dampen the impact of a default, "would insert the Federal Reserve into a very strained political situation and could raise questions about its independence from Treasury debt management issues," English said in the 2011 call, a conclusion he feels remains the case today.

"They'd be very uneager to step into the middle of a big political dogfight," English said in the recent interview, noting that those steps would raise the question of whether the Fed was helping "monetize" federal debt. In the current environment they might even run counter to the central bank's effort to tame inflation.

Perhaps more pointedly, Powell seemed to hate the idea.

After endorsing other options listed as 1 through 7 during a 2013 briefing, the future Fed chief said, "as long as I'm talking, I find 8 and 9 to be loathsome. I hope that gets into the minutes. But I don't want to say what I would and wouldn't do, if we have to actually deal with a catastrophe."

Explainer-From 'loathsome' to routine, Fed has a well-rehearsed debt-limit playbook

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