Before financial markets have another tantrum over the Federal Reserve tapering its bond purchases, as they did in 2013, they might want to look up at the debt ceiling.
While financial markets have been fretting over the possibility that the Fed will start to pull back on its easy money policies before year-end, investors might want to start paying attention to the possibility that a politically intractable debate over the debt ceiling is coming and it could derail any plans that Jay Powell might have to slow asset purchases and raise interest rates.
As the effects of the coronavirus pandemic lessen and the economy grapples with rising inflation (transitory or not), more and more voices on the Fed have made it clear they want to start the taper in 2021.
In remarks on Friday, Fed chairman Powell himself said that “At the FOMC’s recent July meeting, I was of the view, as were most participants, that if the economy evolved broadly as anticipated, it could be appropriate to start reducing the pace of asset purchases this year.”
But while Powell reiterated that he is in no rush to raise interest rates, he also went on to caution that “The intervening month has brought more progress in the form of a strong employment report for July, but also the further spread of the delta variant.”
The spread of the coronavirus delta variant mostly through unvaccinated communities is beyond the control of monetary policy experts, but some economists are cautioning that Powell might want to expand his scope to see what else is outside his power.
“If delta derails employment growth, taper is obviously delayed – and do not underestimate the potential for market disruption tied to the debt ceiling to also delay (but not deny) the start of taper,” Steve Blitz, chief economist at TS Lombard wrote in a note on Friday.
In early August, U.S. Treasury Secretary Janet Yellen, who preceded Powell at the Fed, began conducting emergency cash-conservation steps in order to keep the government within its borrowing limit. The move came one week after the two-year suspension of the debt ceiling expired on July 31, during which the national debt ballooned from $22 trillion to $28.5 trillion, as the federal government spent more on relief programs to combat the impact of the pandemic and the Federal Reserve helped to finance the debt.
Yellen’s so-called “extraordinary measures” are only projected to last for three months at the longest, meaning Congress will have to vote to raise or suspend the debt ceiling in October or early November, or the government will have to begin to shut down, but that is the same window of time that the Fed is considering for beginning to wind down its bond purchases.
Republicans have already made it clear that the debate over the debt ceiling will be a partisan one. Some 46 GOP senators signed a letter just days after Yellen’s move to conserve cash, warning Democrats that they will have to find a way to raise the debt ceiling without Republican support if they hope to pass President Biden’s $3.5 trillion infrastructure package which includes money for roads, bridges, and tunnels as well as for education, health, social welfare and a green economy to combat climate change.
“‘Extraordinary measures’ are keeping the show on the road for now,” wrote ING chief international economist James Knightely in a note from Thursday. “But any delay to a budget deal runs the risk of debt downgrades, Fed taper delays and even the possibility of a government shutdown.”
A rancorous partisan showdown in Congress over the debt ceiling would be enough to rankle markets and give the Fed pause, but a full government shutdown would be a disruptive event to a stock market that is at record highs on the Dow Jones Industrial Average
The chaos of a government shutdown coming on top of the delta variant would likely be enough to cause Powell and the Fed to delay the taper even if the number of jobs created in August, September and October exceeds expectations, satisfying one of the two criteria for the central bank to reduce its support for the economy.
Yellen has made it clear that she sees the debate over the debt ceiling coming.
“I respectfully urge Congress to protect the full faith and credit of the United States by acting as soon as possible,” she said in early August, warning that a failure to do so “would cause irreparable harm to the US economy and the livelihoods of all Americans.”
It could also prevent the Fed from effectively managing inflation, which is running at a 30 year high by one measure, at a time when many Americans are just getting back into the workforce after lengthy layoffs due to the pandemic.
“As always,” a note from Citigroup economists posited on Thursday, “The direction of future fiscal policy hinges on political outcomes.”