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WOULD FED CHAIRMAN JEROME POWELL stay on the sidelines this summer if there’s a looming default crisis that could taint U.S. debt? The betting in this town is that Powell eventually may have to get involved.
POWELL’S SPEECH LAST WEEK IN SWEDEN now looks, in retrospect, as a warning from the Fed Chairman that he doesn’t want to get involved in any political issue, including the debt ceiling controversy. He has stated that a Fed bailout is a “loathsome” option.
BUT WHAT IF A DEFAULT LOOKS LIKELY this summer? Would Powell refuse to budge if global markets are in disarray because of a U.S. debt crisis? We think he would have to take action.
HIS MOST LIKELY OPTION would be to jawbone, warning of dire consequences if Congress doesn’t act. If there’s still no deal, Powell would have to consider Fed purchases of Treasury debt that is close to default.
THERE ARE PLENTY OF OPTIONS FOR A LAST-MINUTE REPRIEVE, ranging from the far-fetched (Treasury minting a $1 trillion coin) to the more practical option of a deal between most Democrats and enough Republicans to get the debt ceiling raised. Any capitulation by Republicans probably would cost Kevin McCarthy his job, as dissident House hard-liners reject any deal that doesn’t impose huge spending cuts.
POWELL MUST REALIZE that any sign that he might act to avoid a default would, ironically, be a disincentive to for Congress to cut a deal, since lawmakers would assume that he would act if a default was imminent. And Powell must know that if he takes action to avoid a default, hard-liners in the House would accuse the Fed of complicity in the huge spending binge.
BOTTOM LINE: We think in the next few weeks, Powell will continue to refrain from
getting involved in this fight, while warning that this has to be resolved. But if the threat becomes more imminent, Powell would be faced with a huge threat — U.S. and global markets could lose faith in Treasury debt. Who wants Treasuries if they could default?
WE CONTINUE TO BELIEVE there’s a 60-40 chance that there will be a political deal that avoids default, but that would require deep spending cuts that Republicans will have to detail soon. Both parties seem hopelessly divided, so this crisis could get worse in coming weeks.
THERE WILL BE NUMEROUS assertions from Powell and other Fed officials that they will not get involved in the talks, which seems likely into early summer. But this may boil down to one simple issue: Will the Fed allow the U.S. to default on its debt? At the very last minute, the Fed may have to consider Powell’s “loathsome” option.
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