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Debt ceiling impasse? Fed's 'loathsome' game plan for the 'unthinkable'

Kitco News

(Reuters) - Treasury Secretary Janet Yellen says failure to raise the U.S. debt limit could lead to the unthinkable: a default on government payment obligations. That's an outcome the White House on Friday warned could plunge the economy into recession.

If the impasse in Congress over the $28.5 trillion debt limit isn't resolved before an October deadline, what would the Federal Reserve - the backstop for U.S. financial markets as the lender of last resort - be prepared to do?

As it turns out, Fed Chair Jerome Powell may already have something of a game plan. The country faced a similar crisis over the debt limit in 2011 and again two years later, and at an unscheduled October 2013 meeting, Fed policymakers - including Powell, who was then a Fed governor, and Yellen, who was the Fed's vice chair - debated possible actions in response.

The plan included a process for managing government payments, given the Fed's expectation that Treasury would prioritize principal and interest but would make day-by-day decisions on whether to cover other obligations.

Changes to the Fed's supervision of banks were also planned. Banks would be allowed to count defaulted Treasuries toward risk-capital requirements, and supervisors would work directly with any bank experiencing a "temporary drop in its regulatory capital ratio." The U.S. central bank would also direct lenders to give leeway to stressed borrowers.

Policymakers also mapped out an approach to managing market strains and financial stability risks stemming from a technical default.

They readily agreed to some measures, including expanding ongoing bond purchases to include defaulted Treasuries, lending against defaulted securities and through the Fed's emergency lending window, and conducting repurchase operations to stabilize short-term financial markets.

Other actions sketched out in briefing notes and during the meeting were more controversial, including providing direct support to money markets by buying defaulted Treasury bills, or simultaneously selling Treasuries that are not in default and buying ones that are.

Powell described these approaches as "loathsome."

"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," he said at the time.

Powell added, however, that he wouldn't rule it out in a catastrophic situation, a point also made by several of his colleagues, including Yellen and John Williams, who at the time was San Francisco Fed president and is now head of the New York Fed.

Reporting by Ann Saphir; Editing by Paul Simao

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