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Jul 22

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This time, believe the Fed

The Federal Reserve Chairman once again issues the same grave warnings to Congress that he has been repeating for months:  the economic consequences of failing to raise the U.S. debt ceiling will be “catastrophic”, “self defeating”, and “dire.”  In his semi-annual monetary policy report to Congress last week, Mr. Bernanke said:

Clearly, if we went so far as to default on the debt, it would be a major crisis because the Treasury security is viewed as the safest and most liquid security in the world…It’s possible that simply defaulting on our obligations to our citizens might be enough to create a downgrade in credit ratings and higher interest rates for us, which would be counterproductive, of course, since it makes the deficit worse.”

Importantly, Mr. Bernanke added that  just paying interest on the debt to bondholders may not preserve the nation’s pristine credit rating.  This may be in response to (among other things) S&P’s statment just last week stating (among other things):

Standard & Poor’s has placed its ‘AAA’ long-term and ‘A-1+’ short-term sovereign credit ratings on the United States of America on CreditWatch with negative implications.   Standard & Poor’s uses CreditWatch to indicate a substantial likelihood of it taking a rating action within the next 90 days, or in response to events presenting significant uncertainty to the creditworthiness of an issuer. Today’s CreditWatch placement signals our view that, owing to the dynamics of the political debate on the debt ceiling, there is at least a one-in-two likelihood that we could lower the long-term rating on the U.S. within the next 90 days. We have also placed our short-term rating on the U.S. on CreditWatch negative, reflecting our view that the current situation presents such significant uncertainty to the U.S.’ creditworthiness…

We expect the debt trajectory to continue increasing in the medium term if a medium-term fiscal consolidation plan of $4 trillion is not agreed upon. If Congress and the Administration reach an agreement of about $4 trillion, and if we to conclude that such an agreement would be enacted and maintained throughout the decade, we could, other things unchanged, affirm the ‘AAA’ long-term rating and A-1+ short-term ratings on the U.S. [emphasis added]

Standard & Poor’s takes no position on the mix of spending and revenue measures that Congress and the Administration might agree on. But for any agreement to be credible, we believe it would require support from leaders of both political parties.

Congress and the Administration might also settle for a smaller increase in the debt ceiling, or they might agree on a plan that, while avoiding a near-term default, might not, in our view, materially improve our base case expectation for the future path of the net general government debt-to-GDP ratio. U.S. political debate is currently more focused on the need for medium-term fiscal consolidation than it has been for a decade. Based on this, we believe that an inability to reach an agreement now could indicate that an agreement will not be reached for several more years. We view an inability to timely agree and credibly implement medium-term fiscal consolidation policy as inconsistent with a ‘AAA’ sovereign rating, given the expected government debt trajectory noted above.  [emphasis added]

Further delays in raising the debt ceiling could lead us to conclude that a default is more possible than we previously thought. If so, we could lower the long-term rating on the U.S. government this month and leave both the long-term and short-term ratings on CreditWatch with negative implications pending developments

Further delays in raising the debt ceiling could lead us to conclude that a default is more possible than we previously thought. If so, we could lower the long-term rating on the U.S. government this month [emphasis added] and leave both the long-term and short-term ratings on CreditWatch with negative implications pending developments.

In essence, S&P is not going to fall for a half-baked short-term fix that merely appears that Congress and the Administration value the U.S.’s current AAA rating.  S&P actually provided specific guidelines for Congress and the Administration including “a medium-term fiscal consolidation plan of $4 trillion” over the next 10 years.  Realistically, past history tells us that any future spending cuts that are put forth by Congress rarely, if ever, occur.   S&P is not stupid; they get that.  Thus, they added to the $4 trillion potential agreement that,

If Congress and the Administration reach an agreement of about $4 trillion, and if we to conclude that such an agreement would be enacted and maintained throughout the decade [emphasis added], we could, other things unchanged, affirm the ‘AAA’ long-term rating and A-1+ short-term ratings on the U.S.

Unlike a recent article that highlights the Fed’s reluctance to tell the public the real economic story with its own economic data, I believe the Fed is telling the real story here.  Neverthless, in the same semi-annual monetary policy report to Congress last week, Mr. Bernanke provided additional comments that said pretty much nothing.  In talking about the state of the current economy, Mr. Bernanke said:

On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support…On the other hand, the economy could evolve in a way that would warrant a move toward less-accommodative policy.”

About the author

Nicole Liska

I am a Principal at Fulcrum Inquiry, an accounting and economic consulting firm that performs damage analysis for commercial litigation, forensic accountings, financial investigations, and business valuations. I hold an ABD and MA in economics from the University of California, San Diego. I perform damages analyses and serve as a damages expert witness. My resume is on Fulcrum's website.

Permanent link to this article: http://betweenthenumbers.net/2011/07/this-time-believe-the-fed/

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