Debt Deal Done, Focus Turns Back to Fed on Economy
Even as Congress escapes from its brush with default, political divisions have all but immobilized the levers of fiscal policy, raising pressure on the Federal Reserve to address the nation’s economic lethargy.
Failing to raise the U.S. debt ceiling could lead to an economic catastrophe. But even if the Senate on Tuesday joins the House in agreeing to let the government borrow more money, there is mounting evidence that the political turmoil has made a bad economic situation worse.
Manufacturing activity declined in July, a trade group reported Monday. Unemployment is climbing. So is inflation. And the high pitch of partisan rancor in Congress makes it difficult for either party to advance their incompatible economic agendas.
The deal to raise the debt ceiling would reduce federal spending this year by billions of dollars, exacerbating a broader downturn in federal aid as the stimulus peters out. A payroll tax cut and extended benefits for the unemployed are scheduled to expire at the end of the year.
Ben S. Bernanke, the chairman of the Federal Reserve, said in the spring that it was time to see whether the economy could stand on its own. Last month he said the Fed would consider new steps if conditions deteriorated significantly. As the Fed’s policy-making committee prepares to meet Aug. 9, the drums are beating louder.
“I don’t think they can do anything until we see how much was lost and how much we can recoup,” said Diane Swonk, chief economist at Mesirow Financial. “But if we have persistent weakness, and stagnant employment growth through the third quarter, I just don’t see how they can’t step back into the game.”
The Fed already is engaged in a vast and unprecedented effort to bolster economic growth. It has held short-term interest rates near zero for almost three years, and amassed more than $2 trillion in Treasuries and mortgage bonds to hold down long-term rates. But since the end of June, when it completed its most recent round of asset purchases, the Fed has chosen to stand pat.
Its available options now are modest steps including replacing its promise to maintain low rates “for an extended period” with a more specific commitment, like a six-month minimum. More aggressive steps could include tilting the composition of its investment portfolio toward longer-term Treasury securities, to increase the downward pressure on long-term rates. The most drastic step, which analysts also consider least likely, would be a decision to increase the size of its portfolio.
For the moment, and for as long as possible, the central bank would like to do nothing. There is broad agreement that the unprecedented size of the Fed’s portfolio has complicated its ability to control the pace of inflation, and that additional purchases would exacerbate the difficulty.
Mr. Bernanke has said that growth must weaken and price increases abate. A vocal minority of Fed officials has gone further, arguing the central bank has reached the limit of its powers.
“It seems unlikely that the forces limiting the pace at which U.S. growth is recovering are amenable to monetary policy,” Jeffrey M. Lacker, president of the Federal Reserve Bank of Richmond, said in a speech last week. “Additional monetary stimulus at this juncture seems likely to raise inflation to undesirably high levels and do little to spur real growth.”
The Fed is even less eager to renew its interventions into financial markets. The central bank has hovered on the edge of the debt ceiling debate like a homeowner riding out a hurricane, hoping for limited damage to the lethargic economy.
“I want to eliminate any expectation that the Fed through any mechanism could offset the impact of a default on the government debt,” Mr. Bernanke told Congress in July.
Even if the Congress meets President Obama’s Tuesday deadline for a debt ceiling deal, the ratings agency Standard & Poor’s has warned that it may downgrade long-term Treasury bonds, altering a basic premise of many financial transactions and unleashing smaller but still significant disruptions.
“If a huge amount of harm is being done to the markets and the economy, they will have to consider carefully whether there’s anything they can do to help,” said Donald L. Kohn, who stepped down last June after serving four years as vice-chair of the Fed’s board of governors. “The point of that would be to help the markets get through a chaotic period.”
During a previous debt ceiling standoff, which ran from the fall of 1995 through the spring of 1996, the Fed considered offering loans to banks that did not receive expected payments from the government, and honoring defaulted Treasurys as collateral, according to Alan Blinder, who served as vice chairman of the board of governors at the time.
“We had extensive discussions with the principal clearing banks in New York which then were Chase and Bank of New York,” said Mr. Blinder, now a Princeton economics professor. “What we on the board were most worried about was preserving the remnants of the Treasury market because of its central role in providing liquidity to the whole system.”
The Fed also could buy dollars in the event of a downgrade. Uncertainty already is driving investors to other currencies, and a sharper decline could undermine the dollar’s role as an international reserve currency—a status that has significant benefits for the American economy.
Such a step would be taken at the behest of Treasury, because the administration sets currency policy.
But there are strong reasons to doubt the government would try such an intervention. A weaker dollar could bolster growth by making American exports more attractive. In particular, it could improve the balance of trade with China—while intervening to prop up the dollar would undermine the credibility of American efforts to convince China to stop manipulating its currency.
Perhaps most important, intervening in exchange markets may not prevent the dollar’s fall. “If the dollar were just weak because people had lost confidence in the U.S. government, I don’t see why buying dollars is going to restore confidence,” said Mr. Kohn, now a senior fellow at the Brookings Institution. “The cure for that isn’t intervention. The cure is the government acting like adults."