The Federal Reserve appeared poised a few weeks ago to start pulling back on its unprecedented support for the economy, but surprisingly stopped short out of fear the recovery still was too fragile.
That was before the budget stalemate boiled over in Washington.
Now, with the federal government partially shut down and a looming debt-limit deadline threatening financial market chaos, analysts said it’s highly unlikely that Fed policymakers will reduce their stimulus efforts when they meet at the end of this month.
Some economists don’t even think the Fed will start tapering its $85 billion in monthly bond purchases until 2014, when Janet Yellen will probably take over as its chairwoman. Economists say the shutdown is squelching important federal economic reports, resulting in central bank policymakers flying somewhat blind about the true state of the recovery.
Maintaining the pace of bond purchases would keep mortgage and other long-term interest rates low in hopes of boosting spending and helping the economy deal with the hit from the shutdown and a potential government default.
“It almost certainly means the Fed won’t be tapering this year,” said Mark Zandi, chief economist at Moody’s Analytics. “The uncertainty will freeze them.”
Instead of considering doing less to stimulate the economy, some analysts said Fed officials might need to start doing more.
If the debt limit isn’t raised soon, the government would face a default that would dry up credit markets. That could spur the Fed to take steps to increase liquidity similar to those used during the 2008 financial crisis.
“If there’s an outright default, even if there’s a technical one, there is talk in some circles of the Fed coming in with new liquidity facilities like in 2008-2009,” said Gary Schlossberg, senior economist at Wells Capital Management.
Fed chairman Ben S. Bernanke said last month that concerns about the economic effect of the shutdown and problems raising the debt limit were a factor in the decision not to start tapering in September.
And he said Fed policymakers were prepared to respond if the stalemate turned into a crisis, although he warned that the central bank’s arsenal was “very limited” after more than five years of aggressive action.
“It is the case, I think, that a government shutdown – and perhaps, even more so, a failure to raise the debt limit – could have very serious consequences for the financial markets and for the economy, and the Federal Reserve’s policy is to do whatever we can to keep the economy on course,” Bernanke told reporters.
President Barack Obama’s announcement Wednesday that he was nominating Yellen, the current Fed vice chair, to replace Bernanke when his term ends in January, doesn’t change how the Fed is likely to respond to the shutdown and its effect, said Greg McBride, senior financial analyst at Bankrate Inc.
“She’s been the co-pilot to Bernanke throughout this program of ultra-stimulus, and it just makes it that much easier for her to slide over into the big chair as the Fed has to transition from stimulus to eventually tapering,” he said of the nomination.
Minutes of the Fed’s September meeting, released Wednesday, showed that for several policymakers, the decision not to reduce the stimulus was “a relatively close call.”
At the time, most Fed officials still expected the central bank to start dialing back its $85-billion-a-month bond purchases by year’s end, with the program shutting down in mid-2014 as previously forecast.
But that was before the shutdown.
McBride said the Fed still could taper this year if the shutdown and debt-limit issues are resolved quickly. If not, it might be a while before the Fed pulls back.
“Worst-case scenario, if we have a debt default … and things go haywire, we won’t hear the word ‘taper’ for a very long time,” McBride said. “The Fed will be in a position where they’ll be doing the exact opposite of tapering.”
Barry P. Bosworth, a senior fellow at the Brookings Institution, doesn’t believe there is anything the Fed could do to blunt the effects of a government default.
Even Fed officials have questioned whether their large-scale bond-buying, known as quantitative easing, or QE, is still doing a lot of good, given the risks of pouring massive amounts of money into the financial system, which could lead to higher inflation.
“They already have a large QE program, and its effects are marginal compared to a potential debt default,” said Bosworth, who directed President Jimmy Carter’s Council on Wage and Price Stability during a period of soaring inflation in the late 1970s. “They have exhausted their policy measures in the current effort to sustain a modest recovery.”