Fiscal divisions on Capitol Hill prompt Fed tapering concerns

The growing political stand-off over fiscal policy in Congress could limit the Federal Reserve's drive towards slowing asset purchases in the coming months, some economists say. Over the past few weeks, divisions on fiscal policy between Republicans and Democrats have widened, heightening the risk of a possible government shutdown.

By James Politi
August 13, 2013 6:15 pm
Financial Times

The growing threat of a political stand-off over fiscal policy in Congress could limit the Federal Reserve’s drive towards slowing asset purchases in the coming months, some economists say.

US central bank officials are weighing a tapering of bond buys as early as the next meeting of the Federal Open Market Committee on September 17-18, and are expected to approve such a move as long as the economic data remain relatively strong.

But while figures on employment, inflation, factory activity and housing are expected to be the main drivers of the Fed’s decision, officials will also be monitoring developments on Capitol Hill. Over the past few weeks, divisions on fiscal policy between Republicans and Democrats have widened, heightening the risk of a possible government shutdown as early as October 1, and even a crisis over raising the US borrowing limit between mid-October and mid-November, possibly leading to another brush with a debt default.

A relative minority of economists believe an acrimonious fiscal environment could contribute to a delay in the first tapering move until later this year, especially if the economic data are mixed and Fed officials are on the fence.

“This is going to be an extremely noisy time in Washington – I think the rhetoric is going to be incredibly heated,” says Ethan Harris, a senior global economist at Bank of America Merrill Lynch. “Like everybody else the Fed probably hopes that the bark is worse than the bite but it has to be in their thinking,” he adds, explaining that the fiscal environment was “one of the reasons” he was betting on a December tapering move, even if he said the chance of real “disruption” to the government was only 20 per cent.

Many economists and investors still believe the Fed will start curbing the pace of their support for the recovery – now worth $85bn in monthly bond buys – in September. But some suggest they may have to either pause after the first reduction or even begin asset purchases again if the fiscal outlook deteriorates later in the autumn.

“We think it will take a material slowing in the data to stop tapering from starting in September. The state of play on the debt ceiling and other fiscal negotiations are unlikely to precipitate this, in our view, prior to the September meeting,” says Michael Gapen, a top US economist at Barclays and a former senior Fed staffer. But he adds: “I think what is more likely is a situation whereby the Fed takes purchases down a step in September and any fiscal-induced malaise would mean the Fed would stay at that level longer than previously anticipated. Or, predicated on a major disruption, the Fed could step back in to do more.”

Others dismiss the possibility that congressional friction could affect Fed thinking, as lawmakers have often struck last-minute deals to prevent the worst economic consequences even after a great deal of brinkmanship.

“I’d be stunned if the Fed modified its plans to accommodate the risk of congressional fiscal meltdown. Instead, Bernanke will lean heavily on Congress not to disrupt the recovery, as he did during the fiscal cliff negotiations,” says Sean West, a US policy analyst at the Eurasia Group.

Douglas Handler, a senior US economist at IHS Global Insight, says: “I think the Fed will not react to any government budget crisis that has been politically induced and therefore won’t materially affect the economy’s underlying growth rate.”

The Fed’s monetary policy moves since the financial crisis – including three rounds of quantitative easing – have mainly been based on the fact that economic data and the state of the recovery kept disappointing at each turn. But fiscal considerations were always lurking in the background, contributing to their rationale.

The second round of QE in late 2010 came about as it became clear that no more fiscal stimulus was politically possible. The third round of QE was launched in September 2012 with high-stakes fiscal cliff negotiations looming three months later that could have sent the US economy back into recession had they failed. So the Fed has tended to keep a watchful eye on developments on Capitol Hill, mostly as a potential source of “downside risk” to the economy, which it could become again in the coming months.

On the other hand, the Fed may not flinch in tapering asset purchases unless there is emerging nervousness in financial markets about the budgetary debate, which is not the case now.

“Markets seem to take very calmly the possibility that there could be a terrible fiscal event, they treat it like a very remote possibility. So if the Fed is reacting to the markets’ assessment of the risk, they won’t take it very seriously,” says Gary Burtless, a senior fellow for economic studies at the Brookings Institution, a Washington think-tank. “And suppose the bad event [like a default caused by not raising the debt ceiling] does really happen, I don’t think QE is going to be a way to deal with that, the Fed is going to do something much more drastic and dramatic to keep credit markets from having a meltdown,” Mr Burtless adds.

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