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US debt ceiling fears cast shadow over Fed plans

US Treasury Secretary Steve Mnuchin
Nicholas Kamm | AFP | Getty Images
US Treasury Secretary Steve Mnuchin

The Federal Reserve's plan to start unwinding quantitative easing as early as September could be derailed if Congress fails to tackle the looming deadlock over the US debt ceiling, analysts warn.

Republican failures to win legislative victories — embodied by the collapse of healthcare reforms — last week injected an early bout of nerves into financial markets as investors confronted the possibility of a disorderly stand-off over the US's public debt limit. In a worse-case scenario, this could lead to a government shutdown as well as market turmoil.

While yields on three-month Treasury bills subsided somewhat at the end of last week, jitters have come sooner than during the debt ceiling countdowns of 2011 and 2013, according to Mark Cabana, a strategist at Bank of America Merrill Lynch. This is striking given that Republicans have control of both wings of Congress and the White House, which ought to put them in a stronger position to reach a deal.

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Mark Zandi, chief economist at Moody's Analytics, said it was reasonable for investors to be getting a little nervous. "This is an administration that has shown it can't get anything done. Absolutely nothing," he said.

Congress sets a limit on the federal government's debt in law, which currently stands at $19.8tn. Once the limit bites, the Treasury can no longer borrow and, if it were to exhaust other ways of making payments, it would eventually have to miss, delay or reduce payments.

The Treasury bumped up against the debt limit in March, so it has since then been using so-called "extraordinary measures" to buy Congress more time to act on the debt limit. The Congressional Budget Office and the Bipartisan Policy Center both estimate that those measures will finally expire in early to mid-October.

The risk of a stand-off has implications for monetary policy, as well as markets. The Fed signalled in its latest meeting that it could start paring back its purchases of securities including government debt as soon as its September 19-20 meeting.

Investors said the Fed might choose to wait before starting to curtail purchases of government bonds if the Treasury is grappling with serious bond market turbulence. The central bank showed in early and mid-2016 it is reluctant to make important policy moves when financial markets are going haywire.

Steven Mnuchin, the Treasury secretary, has repeatedly urged Congress to lift the ceiling before its recess, but lawmakers have ignored his pleas, with the House adjourning for its summer break with no resolution in sight.

"It does put them in a little bit of an awkward spot," Mr Cabana said. "The Fed may be thinking we don't want to have our monetary policy decisions unduly influenced by political developments, especially given every other debt limit issue has been resolved."

There are also fears the debt ceiling discussions could get intermingled with other issues in Congress, in particular discussions over the 2018 budget and the potential for a government shutdown after the expiry of the fiscal year on September 30.

Rightwing Republicans, including the Freedom Caucus, have said they will only sign up to legislation addressing the debt ceiling if they get tough conditions on spending attached. They used this gambit against Barack Obama. It is striking now to see them using it against a president and Treasury secretary from their own party.

However, any attempt by conservative Republicans to advance their broader public spending agenda in a debt ceiling bill would likely be immediately rebuffed by Democrats.

On top of this, the Trump administration has been sending confused signals over its debt ceiling strategy.

Mr Mnuchin has been calling for a "clean" bill increasing the debt limit, without any conditions attached. However, Mick Mulvaney, the president's budget chief, has publicly supported the idea of attaching riders to the debt-ceiling increase, creating an impression of internal conflict in the Trump administration.

Both Mr Trump and Mr Mnuchin have said it might be possible to have a "good" government shutdown — heightening the risk of brinkmanship.

Shai Akabas of the Bipartisan Policy Center said most investors have a high level of confidence that the debt limit will get worked out in time. Still, even if just "one iota of doubt" creeps in it will start to affect how they think about the relevant government securities, he said.

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