Following a threat to put the United States' debt on review for downgrade by Moody’s ratings agency, the risks of Washington making a major mistake are rising, according to Lee Hardman, the chief economist at The Bank of Tokyo-Mitsubishi.
“While raising the debt ceiling has proved an increasingly frequent event, having been raised ten times over the last decade, there is now a higher than normal risk that negotiations to extend the debt limit could result in a policy mistake,” said Hardman in a research note.
Hardman assumes a deal will be reached at the 11th hour on August 2, but Moody’s could change its viewby mid-July if no deal is in place.
“Leaving the extension of the debt limit to the 11th hour is undesirable as it increases the risk of heightened financial market instability heading into early August which may exacerbate and extend the ongoing US and global slowdown,” he said.
The best solution for Hardman is an agreement to implement a credible commitment to deal with the long-term deficit alongside raising the debt ceiling.
“In the worst case scenario, should the two sides fail to raise the debt ceiling, the government will be forced to either cut spending by around a third or default on its debt. If sustained both are a recipe for renewed recession,” he said.
“There is also a lesser risk that a compromised deal results in too much or too little fiscal consolidation. More front-loaded tightening next year on top of the expiration of the tax cuts would also raise the risk of another period of sub-trend growth,” Hardman said.
“The dollar has so far remained relatively resilient to ongoing developments, but is likely to become increasingly vulnerable to temporary weakness in the months ahead should negotiations go down to the 11th hour,” said Hardman.