Culte de l'arbre à argent magique (en anglais uniquement)

Key points:

• Looking into “debt ceiling crisis” mitigation, should an accident happen
• The depth of attachment of a large share of the US political class to an “ever accommodative “Fed is concerning
• Shades of central bank independence could determine EM response to higher rates in the US

Our baseline is that economic and electoral rationality will prevail and that the various factions within the Democratic Party will ultimately unite to tag an extension of the debt ceiling to a social and environmental fiscal package which, like the bi-partisan deal on investment, will be smaller than advocated by Biden in his platform. Yet, accidents happen, and we explore how hitting the limit at the middle of this month could be mitigated.

Avoiding a default on interest payments would entail cutting some non-financial expenditure. Available simulations of such an approach are consistent with a “mild recession” after one month of such regime, while the loss of standing of the US bond market could have long-lasting effects on the US interest rate premium. But this “first line of defence” would still be predicated on the US Treasury retaining enough market access to “roll over” maturing securities into new issuance. If this fails, the only solution would be for the Fed to “take out” the tainted bonds from the market. Beyond the likely postponement of the tapering this would entail, the political economy ramifications would be profound. This would be a “dream come true” for proponents of “Modern Monetary Theory”: The Fed would be faced with extreme fiscal dominance, downgraded to the role of mere auxiliary of the government. A temptation, as a next step, would be to withhold interest payments on the debt held by the Fed, to gain more room for manoeuvre on non-financial payments. A dangerous slippery slope.

Beyond the mitigation of a possible although still unlikely default, we are concerned with the depth of attachment of large segments of the US political class to an “eternally supportive” central bank, which may threaten Powell’s chances to be re-appointed for a second mandate. This would be detrimental to perceived central bank independence, while using ultra-loose monetary policy to “offset” constrained fiscal action would be nefarious. The structural problems of the US economy can’t be solved by lower interest rates.

Central bank independence also looms large in emerging markets, as we explore whether the “taper tantrum” of 2013 can shed light on how EMs would deal with Fed tapering. A big difference with 2013 is that at the time, the foreign financial position of many EMs had deteriorated for several years. External imbalances forced monetary tightening then. Today, it is inflation which is the main challenge facing central banks there, and we take Brazil and Turkey as polar examples of how political constraints can impact the monetary stance.