Fed planning for potential U.S. default

PHILADELPHIA Thu Jul 21, 2011 11:18am IST

Chairman of the Federal Reserve Ben Bernanke testifies in front of the Senate Banking, Housing and Urban Affairs Committee about ''The Semiannual Monetary Policy Report to the Congress'' on Capitol Hill in Washington, July 14, 2011. REUTERS/Larry Downing

Chairman of the Federal Reserve Ben Bernanke testifies in front of the Senate Banking, Housing and Urban Affairs Committee about ''The Semiannual Monetary Policy Report to the Congress'' on Capitol Hill in Washington, July 14, 2011.

Credit: Reuters/Larry Downing

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PHILADELPHIA (Reuters) - The Federal Reserve is actively preparing for the possibility that the United States could default as a deadline for raising the government's $14.3 trillion borrowing limit looms, a top Fed policymaker said on Wednesday.

Charles Plosser, president of the Philadelphia Federal Reserve Bank, said the U.S. central bank has for the past few months been working closely with Treasury, ironing out what to do if the world's biggest economy runs out of cash on Aug. 2.

"We are in contingency planning mode," Plosser told Reuters in an interview at the regional central bank's headquarters in Philadelphia. "We are all engaged. ... It's a very active process."

Plosser said his "gut feeling" was that President Barack Obama and Congress will come to an agreement to increase the Treasury's borrowing authority in time to avert a default on government obligations.

Obama was due to meet with top Republicans in Congress on Wednesday to discuss the latest attempts to end the dispute over raising the country's debt ceiling, a row which has raised the prospect of the Treasury Department running out of money to pay its bills next month.

The Treasury has repeatedly said default was unthinkable and that there was no alternative to raising the debt ceiling. Plosser's remarks marked the most extensive public comments yet on preparations for a default from a U.S. official.

A Treasury spokesperson could not be immediately reached for comment.

One aspect of the Fed's contingency planning is purely operational: the Fed is developing procedures about how the Treasury would notify it on which checks would get cleared and which wouldn't, Plosser said.

The Fed effectively acts as the Treasury's bank -- it clears the government's checks to everyone from social security recipients to government workers.

"We are developing processes and procedures by which the Treasury communicates to us what we are going to do," Plosser said, adding that the task was manageable. "How the Fed is going to go about clearing government checks. Which ones are going to be good? Which ones are not going to be good?"

"There are a lot of people working on what we would do and how we would do it," he said.

Plosser added that there are difficult questions that the Fed itself had to grapple with.

The Fed lends to banks at the discount window against good collateral. But what happens if U.S. Treasuries no longer fit that bill?

"Do we treat them as if they didn't default, in which case we would be saying we are pretending it never happened? Or do we treat them as if they defaulted and don't lend against them?" Plosser said. "Those are more policy questions."

Plosser, who was a vocal critic of some of the Fed's extraordinary lending during the financial crisis -- which he said veered into fiscal policy and risked the central bank's independence -- warned it would be crucial for the Fed not to do the Treasury's work for it.

"We have to be very careful that we don't become, that we don't conduct fiscal policy in this context," he said. "That we don't substitute for the inability of the Treasury to borrow in some circumstances."

INCLINED TO TIGHTEN

Plosser, a noted policy hawk on inflation, argued the Fed might need to raise interest rates before the end of the year, despite recent evidence of renewed economic weakness.

He said he expects the economy to grow at a 3-3.5 percent annual rate over the second half of 2011 with the jobless rate declining to around 8.5 percent by year's end.

"The more my forecast comes to fruition the more I'm going to feel like we may have to act," said Plosser, who is a voting member of the Fed's monetary policy-setting committee this year. "I'd like to have a little more confidence in that forecast."

Plosser pinned the slowdown in economic growth over the first half of the year to "easily identifiable" factors, such as weather, a spike in oil prices and supply disruptions from Japan's earthquake. He also cited uncertainty stemming from Europe's fiscal morass and the wrangling over U.S. debt in Washington.

"I don't see the fundamentals of the economy as changed that much," he said. "Yeah, there's been some shocks and disruptions, but the underlying forces that are going to cause us to continue a slow, moderate recovery are still in place."

That said, the Fed, which is charged with ensuring financial stability, would clearly feel the responsibility to step in as a lender of last resort if markets seized up after a U.S. default, he added.

Fed Chairman Ben Bernanke last week warned that a default could have "catastrophic" effects on financial markets.

Plosser, a former dean of the Simon School of Business at Rochester University, was more circumspect.

"It could be very bad. At some level we don't really know what the consequences could be. It could be very serious. It could be less serious. Do we really want to run that experiment?"

(Editing by Chizu Nomiyama and Leslie Adler)

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