Federal Reserve can’t rescue debt debacle

July 26, 2011

Could the Federal Reserve bail Congress and the Obama administration out of their standoff over the debt ceiling? No way, no how, according to recent testimony by the Fed chairman and people who study the central bank.

With the government about to run out of cash to pay its bills without an increase in the legal limit on how much debt it can issue, speculation has run rampant in financial and political circles that the Fed and its chairman, Ben S. Bernanke, could use their almost unlimited ability to print money to find a way out.

Fed officials are monitoring the situation, and Bernanke and William C. Dudley, president of the Federal Reserve Bank of New York, met with Treasury Secretary Timothy F. Geithner late last week to discuss options. The Fed acts as the “fiscal agent” for the Treasury, a role akin to being the federal government’s banker.

But despite that role, considerable legal restrictions on what the Fed can do make it hard to imagine the central bank being able to address the immediate crisis. And there is no appetite within the independent-minded Fed to intervene in a fundamentally political dispute, particularly one as polarizing as how much the government should spend and how it should pay for it.

“I want to eliminate any expectation that the Fed through any mechanism could offset the impact of a default on the government debt,” Bernanke said at a congressional hearing this month.

There has been speculation that if a downgrade in the U.S. credit rating scared investors away from Treasury bonds, the Fed could step in and buy them. This approach has many problems.

For one thing, the Fed is legally prohibited from buying debt directly from the Treasury. Even if it were to buy debt on the open market, which it is allowed to do, it would not help the fundamental problem of the government lacking the legal capacity to borrow enough money to pay its obligations.

Finally, the Fed’s ability to buy and sell Treasury securities is a tool of monetary policy — the way it increases and shrinks the money supply to affect economic activity and price levels. Central bankers seek to guard their independence and Fed leaders probably would increase their purchase of Treasury bonds only if they expected the unemployment rate to rise or inflation to fall lower than their 2 percent target.

The Fed’s policy committee would resist any step meant only to make up for investors losing their appetite for U.S. bonds. When a central bank “monetizes the debt,” or prints money to lend to a government, it often loses its credibility as being politically independent and high inflation frequently follows.

The Fed probably would be poised to fulfill its normal responsibilities of offering emergency loans to banks that need help if disruptions in the Treasury bond market created a cash shortage.

“If it looks like the financial system is freezing up, the Fed has a mandate to maintain financial stability and could step in to keep things from really turning bad, but that’s if the markets really took things very negatively,” said Peter Hooper, chief economist at Deutsche Bank and a former Fed staff member. “They would not want to step in to try to ease the policy impasse on fiscal policy.”

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