Summary: Recent Federal Reserve minutes indicate that they are prepared to act to maintain financial stability in the event of a financial system shock due to a debt ceiling issue. Based on discussions during the debt ceiling crises in 2011 and 2013, potential measures could include ending/suspending quantitative tightening, initiating temporary asset purchases, initiating repurchase and reverse repurchase operations, assisting banks through the discount window, providing support for money market funds, and even purchasing defaulting Treasury bonds directly. However, the Federal Reserve will not permit the Treasury Department to overdraw.
Fed minutes released this week show that the Federal Reserve is ready to act to maintain financial stability if the debt ceiling problem shocks the financial system. As the debt ceiling deadline approaches, the Federal Reserve's possible interventions in a U.S. default scenario have become the focus of market attention.
Records from the Federal Reserve officials' discussions during the debt ceiling crises in 2011 and 2013 show that policymakers might take a series of steps to prevent a full-blown financial crisis. These measures could include ending/suspending quantitative tightening, even temporarily initiating asset purchases, starting repurchase/reverse repurchase operations, rescuing banks through the discount window, supporting money market funds, directly buying defaulting Treasury bonds, although the Federal Reserve will not permit the Treasury Department to overdraw.
Currently, the expectation on Wall Street is that if the U.S. Treasury Department runs out of funds, it will prioritize repayment of federal debt and payment of interest and principal on U.S. Treasury bonds, as this is the cornerstone of the global financial system. However, Treasury Secretary Yellen has not yet provided specifics on what would happen if funds run out. This Friday, Yellen wrote to congressional leaders about the debt ceiling issue, projecting that debt ceiling measures will be exhausted by June 5th.
#Ending/Suspending Quantitative Tightening
If the market is in a state of "chaos", the Federal Reserve may not want to withdraw liquidity from the banking system. At that time, it might slow down or even stop the current quantitative tightening measures. Currently, the pace of the Federal Reserve's balance sheet reduction is $60 billion in U.S. Treasury bonds and $35 billion in mortgage-backed securities per month.
In extreme cases, the Federal Reserve may even decide to temporarily initiate asset purchases, buying U.S. Treasury bonds that are not in default, to support the market, as it did during the COVID-19 pandemic.
#Repurchase Operations
If a technical default occurs in U.S. Treasury bonds, it may disrupt the repurchase market, which is a key part of the U.S. financial system. In fact, some sectors of the repurchase market have already seen some upward pressure on interest rates this week, and if a real default occurs, repurchase market rates will soar. At that time, the Federal Reserve could provide liquidity by injecting cash, using non-defaulting Treasury bonds and other eligible assets as collateral.
The Federal Reserve has established a standing repurchase agreement facility, which can quickly expand to accommodate any required amount. In addition, the Federal Reserve can consider expanding the range of counterparties eligible to use this program.
#Reverse Repurchase
If market turbulence leads to a sharp increase in demand for high-quality short-term securities, causing the interest rates on related assets to drop to excessively low levels, the Federal Reserve can temporarily expand its reverse repurchase scale to provide a haven for money market funds. Currently, the Federal Reserve's reverse repurchase tool has more than $2.2 trillion in funds.
Market participants point out that repurchase and reverse repurchase operations might occur simultaneously. This is to meet the market's liquidity needs and maintain a stable interest rate level, ensure the smooth operation of the financial market, and provide support for the implementation of monetary policy.
#Bank Loans T
he Federal Reserve's discount window gives it the ability to lend to banks, using collateral as a guarantee. During the peak of the COVID-19 pandemic, the banking industry sought help from the discount window. In the event of an anomaly in the banking system, the banking industry may once again utilize this tool.
From the Federal Reserve officials' discussions in 2011 and 2013, it can be inferred that the officials agreed that the Federal Reserve will continue to accept defaulted Treasury bonds as collateral for discount window loans and repurchase transactions. Defaulted Treasury bonds will be valued at market prices, implying a discount. However, officials were concerned about being or being perceived as a market maker for defaulted Treasury bonds. Therefore, they discussed the issue of purchasing limits for defaulted Treasury bonds.
#Money Market Funds
If massive fund outflows occur in money market funds due to investors avoiding investing in Treasury bonds, it could pose a significant danger, as these funds are the main buyers of short-term U.S. Treasury bonds.
In 2013, the current Federal Reserve Chairman and then Federal Reserve Board Member Jerome Powell pointed out that the ultimate risk is that U.S. Treasury bonds cannot be fully sold at auction, which would result in the U.S. government not having enough cash to repay maturing bonds, leading to a catastrophic outcome.
More than a decade ago, Federal Reserve staff proposed related measures: opening liquidity facilities for money market funds, or directly purchasing Treasury bonds. Many Federal Reserve decision-makers favor buying Treasury bonds because it can reduce the moral hazard associated with rescuing money market funds.
#Direct Purchase of Defaulting Treasury Bonds
The Federal Reserve can buy defaulting Treasury bonds directly or exchange non-defaulting Treasury bonds it holds for defaulting Treasury bonds held by the public. Powell referred to this practice as "repugnant" in 2013. But he also stated that he does not rule out this possibility in extreme cases. Generally speaking, the probability of this plan is low.
#Overdraft is not an Option
According to the results of discussions in 2013, Federal Reserve officials believe that they would only accept occasional overdrafts from the Treasury General Account (TGA), but the Federal Reserve would not provide a certain credit limit to the Treasury Department. The TGA is the fund account held by the Federal Reserve on behalf of the Treasury Department. The Federal Reserve believes that allowing the Treasury Department to overdraw could irreversibly damage the independence of the Federal Reserve. In addition, overdrafts could lead to additional unpredictable costs.
