Federal Reserve won't solve debt ceiling crisis

If the market comes crashing or runs out of authority to borrow, there will not be much that the Fed can do to help. Bernanke has warned Congress that the debt ceiling needs to be raised or the country will face many problems.

By Chris Isidore
July 26, 2011: 10:50 AM ET
CNN MONEY

NEW YORK (CNNMoney) -- If Congress doesn't come together on a debt ceiling deal by next week and markets start tumbling, don't expect the Federal Reserve to come riding to the rescue.

The central bank won't sit idly by if the financial system starts to meltdown in the aftermath of the federal government running out of authority to borrow. But experts say stabilizing bond or stock prices will likely be beyond the Fed's control.

"They don't have the power to dictate what the markets are going to do," said Dan Seiver, a finance professor at San Diego State University. "If the Fed tried to stem the tide, they couldn't do it. They'd be spitting into the wind."

Since the financial crisis of 2008, the Fed pushed trillions of dollars into the economy to restart growth and job creation, with mixed results. Most recently, it purchased $600 billion in long-term Treasuries through a process known as quantitative easing or QE2.

Famous Fed flubs

Fed Chairman Ben Bernanke has repeatedly warned Congress that it's important for the debt ceiling to be raised. He testified before both House and Senate committees earlier this month that failure to do so would have a "calamitous" effect on the economy, jobs and future government deficits.

But the Fed probably won't trot out QE3 as an emergency response to a debt ceiling breach, at least not right away.

"I don't think the Fed is going to try to bail out the mistakes of Congress," said Lyle Gramley, a retired Fed governor. "What the Fed has left in the way of ammunition, they would wait and use when they see the economy is responding badly to events." But he said that will come months down the road, not days or hours after the deadline is breached.

If the United States credit rating is downgraded and markets begin to respond, the Fed likely will move to pump some cash into the system -- at least enough to make sure banks can still function normally in a period when there are doubts about the value of U.S. Treasuries.

William Poole, former president of the St. Louis Fed, and now senior economic adviser for Merk Investments, likens such action to the Fed's response to the wake of the 1987 stock market crash or the 9/11 terrorist attacks, or even the actions of the Bank of Japan in the wake of March's earthquake and tsunami.

But while those actions may soothe markets and relieve some of the fallout, they won't solve the underlying problem because the Fed can't pay the government's bills.

"The Fed clearly could make a difference as it did in those cases," Poole said. "But it can't resolve the problem. The situation would have to be resolved by the Congress increasing debt limit."

So far, prices on U.S. Treasuries have stayed relatively high, with yields remaining relatively low. But there are worries that could change suddenly if Congress surprises investors and doesn't come to a solution by the Aug. 2 deadline.

"My guess is Bernanke will do everything in his power to keep financial markets from panicking too much, making massive amounts of liquidity available, making guarantees, desperately trying hold things together," said Dean Baker, co-director of the Center for Economic and Policy Research.

"If it seems like they're only going to go a couple of hours past the deadline, he might be able to do that. But if Democrats and Republicans are still throwing chairs at each other, it's going to be hard to hold things together. In that case he's not going to be able to keep interest rates from soaring through the roof."

While the central bank rushed to bail out Wall Street giants during the crisis of 2008, it won't be able to come to the rescue if the debt ceiling brings about a new crisis.

"The Fed can't solve this fundamental impasse. That's not their role," said Poole.

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