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Inside the Fed’s Playbook for a Dollar Default

Christopher M. Russo
Barron's Magazine
Published June 11, 2021 (1018 words)

It’s that time again: The national debt limit suspension is set to expire on July 31. If Congress and the president do not raise or resuspend that ceiling, they will force the U.S. Treasury to default. The Federal Reserve has planned for such a crisis: In case of dollar default, break glass. I know their playbook. I’ll read you in using their own words.

Let’s be clear: The risk of a dollar default is low. As Treasury Secretary Janet Yellen said in 2011, when she was vice chair of the Federal Reserve, the debt limit “usually turns out to be just theater,” though “there’s more capacity for mischief here than usual.” She was right. That year, President Barack Obama and congressional Republicans brought the country down to the wire. Narrowly avoiding default, the U.S. government received its first credit downgrade. In the aftermath of the crisis, Jerome Powell, now Fed chairman, described it as a “self-inflicted wound.”

Today, lacking a filibuster-proof Senate majority, Democrats cannot power through a resuspension on a party-line vote. Assuming Democrats do not use parliamentary judo, they will soon clash with Republicans over the budget once again.

Each time, the Fed is caught in the middle. In April 2011, Brian Sack, then-manager of its securities portfolio, described the likely economic consequences: “a bigger risk premium priced into the Treasury curve, a weaker dollar, and downward pressure on U.S. asset prices.” In June 2011, he also described the likely financial market consequences: a loss of liquidity and greater volatility in the Treasury market, bleeding over into the broader financial system. In particular, yields would rise for Treasury securities with default risk. Conversely, as the Treasury redeems debt and depletes cash on hand, repo rates could be pushed negative as the collateral supply declines and reserve balances increase.

At an October 2013 meeting, Fed policymakers discussed plans for how to respond. They had not revised those plans as of December 2015, the last meeting for which transcripts are currently available. What about the intervening years? I led the New York Fed’s forecasts during the 2019 debt limit fight, the one that created the two-year deal set to expire. Having advised policymakers on these issues, take it from me: The Fed has too much on its hands to fix what hasn’t broken.

Here’s that playbook:

First, the Fed made plans for payments, laid out by Senior Assistant Director Susan Foley. If instructed by the Treasury, Fed staff will roll forward the scheduled payment of principal and interest in one-day increments. While still in default, this intervention will allow continued trading of these securities among market participants, including in Fed operations. Concerning other payments: “Each evening, the Treasury will make a decision whether to release or delay payments based on [cash] balance projections for the next day.” Importantly, “Payments that are made would be settled as usual, and financial institutions and consumers should have confidence that payments made would not be rescinded.”

Next, policymakers mapped out plans for bank supervision and regulation, led by Director Michael Gibson. The Fed will treat defaulted Treasury obligations the same as nondefaulted obligations. Their regulatory treatment will remain the same, including their capital-requirement risk weights. Moreover, these securities “will not be adversely classified or criticized by examiners.” He acknowledged the potential for a temporary decline in capital ratios due to balance sheet growth and for borrowers to experience temporary financial stress. In each case, supervisors would work with the bank to determine whether it was “still in fundamentally sound condition” despite the “temporary drop in its regulatory capital.”

The Fed also developed plans for monetary policy, set out by Secretary Bill English. A default would have “significant consequences for the Fed’s monetary policy and financial stability objectives. Even so, policymakers “presumably want to avoid the impression that the Federal Reserve was effectively financing government spending.” The Fed should avoid “the subservience of our monetary policy objectives to the Treasury’s financing needs,” as then-Richmond Fed President Jeffrey Lacker put it.

English outlined three groups of options.

The first allows the Fed to transact with defaulted Treasury obligations at market prices, “so long as it seems certain that delayed interest and principal payments will be made in full and in relatively short order.” The securities would be eligible for “outright purchases, securities lending, rollovers, repos to keep the federal funds rate in its target range, and discount window lending.”

The second group of options eases strains in money markets. Policymakers could instruct the New York Fed to conduct reverse repurchase operations to “provide unblemished Treasury collateral to the market.” By providing collateral and reducing reserves, these operations would alleviate the pressure for negative repo rates. Similarly, policymakers could instruct the New York Fed to conduct repurchase agreements to alleviate higher rates resulting from market dysfunction.

Third, after exhausting its prior options, the Fed could move the defaulted securities onto its balance sheet using targeted purchases or swaps. By far, this set of options is the most contentious. Powell described them as “loathsome” but would be willing to accept them “under certain circumstances.” His reluctance? “The institutional risk would be huge. The economics of it are right, but you’d be stepping into this difficult political world and looking like you are making the problem go away.” Lacker called it “beyond the pale.” John Williams, then-San Francisco Fed President and now at the New York Fed, supported keeping those options on the table. “Apparently I am beyond the pale,” he joked.

There appeared to be broad support for the first and second groups of options. Despite significant reluctance, no Fed governor or president categorically rejected the third group.

As things stand today, all options are on the table, and the stakes have never been higher. My message to Washington is simple: Do not make the Fed use any of them. Yes, despite the serious institutional risks recognized by all, the Fed will attempt to mitigate the “grave threat” of a dollar default. But with each unprecedented intervention, they weaken their credibility and strengthen moral hazard. One day, they won’t be able to ride to your rescue.