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MNI: Fed To Keep Any Emergency US Default Response To Minimum

MNI (Washington)

Chair Jay Powell is wary of extraordinary Fed actions to save the U.S. economy if the Treasury defaults.

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The Federal Reserve stands ready to provide liquidity and calm any financial turbulence that could follow a technical default by the U.S. Treasury, but Chair Jay Powell would be loathe to take actions that may politicize the Fed, former senior officials and analysts told MNI.

Senate Democrats and GOP leaders reached a deal Thursday to raise the debt ceiling until early December, pushing back the so-called "drop-dead date" for a U.S. default by a couple of months, but the parties could find themselves at another impasse by year-end.

Treasury could prioritize payments to protect the Treasuries market if the debt ceiling is not raised. If it doesn't, the U.S. central bank would be prepared to accept defaulted Treasuries as collateral at its discount window and repo facilities to keep markets working well.

The bar is extremely high for the Fed to actively purchase defaulted securities in the open market. More extreme options such as helicopter money or working with Treasury to mint a trillion-dollar coin are seen as off the table completely, the former officials said.

"The Fed would be reactive, trying to prevent systems crashing and things like that," seeing its role as "more in the nature of trying to accommodate, technically, whatever the Congress and Treasury required, and not to independently do anything," former New York Fed research director Jamie McAndrews told MNI.

DAY-BY-DAY

The Fed can soothe markets through the communications channel, said Cornelius Hurley, former assistant general counsel of the Fed's Washington-based board of governors, who compared the situation to Mario Draghi's "whatever it takes" moment. Draghi was able to instill confidence with his words alone.

Fed and Treasury staff have considered a range of contingency tools, and "the Fed can do a lot of things just by saying it's going to do those things," he said.

As a first step, faced with a technical default on select securities, the Treasury would extend their maturities day by day under the assumption that investors will be made whole in short order. The Fed would play its part to sustain markets through that period by also accepting those defaulted Treasuries as collateral in exchange for cash and buying defaulted Treasuries for its own balance sheet.

But there would be a danger of operational glitches across Fedwire, dealer systems and exchanges as Treasury attempts the unprecedented action of extending maturities. Idiosyncratic requests from investors and rising borrowing costs in parts of the bills market could also strain market plumbing, and that could spread to risk markets.

The repo market, after its 2019 meltdown, is now seen as on sound footing based on the amount of excess liquidity in the system and the Fed's new standing repo facility, which would help mitigate any reserves allocation issues. But yields could spike across the curve, threatening a spillover to the real economy and forcing the Fed to actively push liquidity into the market.

POLITICAL CONSIDERATIONS

Powell in 2013 appeared less willing than his colleague Janet Yellen to deploy such extraordinary measures, lest it embolden lawmakers to regularly renegotiate the debt limit, according to emails and transcripts from the episode.

"The political hurdles are very, very high," especially with his renomination process in play, Derek Tang of Monetary Policy Analytics told MNI. "Powell doesn't want to be confronted at a hearing six months later about 'on what basis did you take these actions?' He would want to point to something concrete, say huge bid/ask spreads in Treasuries -- something that's already happened rather than an expectation it will happen."

Records from the 2013 debt ceiling episode show the Fed chair "very clearly doesn't want the Fed to be the safety net or scapegoat for any of this," Tang said.

BANANA REPUBLIC

Purchase operations to remove defaulted Treasuries from the market and selling the securities the Fed owns would be a "last resort" that crosses into the territory of directly financing the government.

A money market funding facility "would finance all banks, it's a much wider universe" compared to the primary dealers with sole access to the standing repo facility, said Stephen Cecchetti, former director of research at the New York Fed and a longtime consultant to various parts of the Federal Reserve system.

But ideas such as the trillion dollar coin are non-starters, he said. "If you want to retain your position as a safe-haven and you want to be a bedrock part of the reserve portfolio of foreign governments and central banks, this kind of thing could be really damaging," Cecchetti said.

"It makes you look like a banana republic, and imagine what it does to your status as a safe-haven."