Fears of a ‘taper tantrum’ in financial markets may be overshadowed by conflict over US debt ceiling

Before the financial markets have another tantrum over the Federal Reserve’s phasing out of bond purchases like they did in 2013, they may want to look at the debt ceiling.

While financial markets worried about the possibility that the Fed could begin withdrawing from its accommodative money policy before the end of the year, investors may want to pay attention to the possibility of a politically intractable debate over the debt ceiling, which could derail any plan by Jay Powell to slow asset purchases and raise interest rates.

As the effects of the coronavirus pandemic wane and the economy grapples with rising inflation (transient or not), more voices over the Fed have made it clear that they want to begin winding down in 2021.

Commenting on Friday, Fed Chairman Powell himself said: “At the recent FOMC meeting in July, I felt, like most participants, that if the economy develops broadly as expected, it may be appropriate to pace of asset purchases this year.”

See: Fed Chair Powell Says He’s Supporting Weaning Bond Purchases This Year

But while Powell reiterated that he is in no rush to raise interest rates, he also warned that “the intervening month has brought more progress in the form of a strong July employment report, but also the further spread of the delta variant.”

The spread of the delta strain of the coronavirus, primarily through unvaccinated communities, is beyond the control of monetary policy experts, but some economists warn that Powell may want to expand his scope to see what else is beyond his power lies.

“If delta derails employment growth, the winding-down is clearly slowing – and don’t underestimate the potential for market disruption associated with the debt ceiling to also delay (but undeniable) the start of the run-down,” wrote Steve Blitz, chief economist at TS Lombard in a note on Friday.

In early August, US Treasury Secretary Janet Yellen, who preceded Powell at the Fed, began implementing emergency cash-saving measures to keep the government within its borrowing limit. The move came a week after the two-year debt ceiling suspension expired on July 31, during which the national debt rose from $22 trillion to $28.5 trillion as the federal government spent more on emergency relief programs to mitigate the impact of the pandemic. and the Federal Reserve helped to finance the debt.

Yellen’s so-called “extraordinary measures” are expected to last up to three months, meaning Congress will have to vote in October or early November to raise or suspend the debt ceiling, otherwise the administration will have to start shutting down, but that is the same time frame that the Fed is considering starting to phase out its bond purchases.

Republicans have already made it clear that the debt ceiling debate will be partisan. About 46 GOP senators signed a letter just days after Yellen’s money-saving action, warning Democrats they will have to find a way to raise the debt ceiling without Republican backing if they hope to get the president’s $3.5 trillion infrastructure package. Biden, including money for roads, bridges and tunnels, as well as for education, health care, social welfare and a green economy to combat climate change.

“‘Extraordinary measures’ will keep the show on track for now,” ING chief economist James Knightely wrote in a note Thursday. even the possibility of a government shutdown.”

A rancorous partisan showdown in Congress over the debt ceiling would be enough to disrupt markets and give the Fed a pause, but a complete shutdown of the government would be a disruptive event for a stock market at record highs on the Dow Jones Industrial Average DJIA,
+0.69%,
S&P 500 SPX,
+0.88%
and Nasdaq COMP,
+1.23%.

The chaos of a government shutdown that comes on top of the delta variant would likely be enough to push Powell and the Fed to delay winding down, even if the number of jobs created in August, September and October exceed expectations , and meets one of two criteria for the central bank to reduce its support to the economy.

Yellen has made it clear that she sees the debt ceiling debate coming.

“I respectfully urge Congress to protect the full faith and credit of the United States by acting as quickly as possible,” she said in early August, warning that failure to do so “would cause irreparable harm.” to the American economy and the livelihoods of all Americans.”

It could also prevent the Fed from effectively managing inflation, which is at the highest level in 30 years by one measure, at a time when many Americans are just returning to work after lengthy layoffs caused by the pandemic.

“As always,” a note from Citigroup economists said on Thursday, “the direction of future fiscal policy depends on political results.”

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