Congress Is the Biggest Risk to the Economy

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Congress Is the Biggest Risk to the Economy

It sure would have been great to hear Federal Reserve Chairman Ben Bernanke start last week’s press conference like this: “Sorry toc psych you out, but Congress is the biggest risk to the U.S. economy, so we have to keep buying $85 billion worth of bonds each month.”

Instead, Bernanke’s defense of the Fed’s monthly bond-buying program, fondly known as Quantitative Easing or “QE3,” included a three-pronged rationale: (1) the labor market remains weak, (2) the recent rise in interest rates could slow down the economy and (3) lawmakers in DC could throw everything for a loop if the government were to shut down or if the nation hits the debt ceiling in October.

Before diving into the three Fed concerns, let’s reflect on how Bernanke amped up investors’ anxieties with “taper talk”. During Congressional testimony on May 22, Bernanke discussed reducing bond purchases, saying:

If we see continued improvement and we have confidence that that’s going to be sustained then we could in the next few meetings… take a step down in our pace of purchases. If we do that it would not mean that we are automatically aiming towards a complete wind down. Rather we would be looking beyond that to see how the economy evolves and we could either raise or lower our pace of purchases going forward.”

Bottom line: if the economy were to improve, the Fed would pull back on its stimulus. After theJune FOMC meeting, Bernanke offered more specific parameters that would argue for a change in bond buying: when the national unemployment rate drops to 7 percent, it would indicate that the economy would have improved “substantially”, and that it would be appropriate to begin tapering within the next few meetings.

OK, so now into the Fed’s three worries.

1. The labor market remains weak. Despite dropping to 7.3 percent (from 8.1 percent when the Fed launched QE3), Bernanke is not convinced that all is rosy on the employment front. Maybe officials were spooked by the last three reports, which indicated that job creation slowed to 149,000 on average, from 172,000 in the previous three months or that long-term unemployment and broader unemployment remains too high.

2. The recent rise in interest rates could slow down the economy. There was some irony in Bernanke using rising interest rates as a reason to maintain bond buying: rates skyrocketed because HE started talking about pulling back on the program! But maybe rates rose higher and faster than the Fed had anticipated. Regardless, Bernanke is worried that higher interest rates “could slow the pace of improvement in the economy and labor market”. There was one other troubling issue with regard to interest rates: the biggest jump in rates occurred between June and July, but there was nary a mention of higher rates posing downside risk in the Fed’s statement from the July 30-31 meeting.

3. Lawmakers in DC could throw everything for a loop. Fiscal uncertainty appears to be the largest unknown that the central bank faces and what was likely the most important reason for holding firm on current policy. Although the Autumnal Equinox will have passed, the heat index is likely to soar in Washington DC next week, as lawmakers duke it out over two fiscal issues: the funding of the government and the debt ceiling. House GOP leaders led a successful effort to pass a bill (230-189) that keeps the government open for business, but eliminates funding of the Affordable Care Act. This week, the Senate is expected to restore ACA funding and then send a stand-alone continuing resolution to fund the government back to the House.

You can see how quickly this could get ugly and might lead to a partial government shutdown on October 1, the start of a new budget year. On top of the pesky issue of funding the government, the nation will likely reach the debt ceiling limit of $16.7 trillion in mid October.

The Fed likely learned a painful lesson from the summer 2011 debt ceiling showdown. The central bank had just concluded its second round of bond buying in June 2011 (the $600B QE2 started in August 2010) so there were no active policies in place when Congress went at it in August 2011. In the aftermath of the debt ceiling smack down, S&P lowered the US credit rating by a notch; economic growth was nearly halved, falling from 2.5 percent in Q2 to 1.3 percent in Q3; the stock market tumbled by 17 percent; and the Fed reacted by introducing “Operation Twist,” in an effort to keep longer-term interest rates low and to spur economic activity.

Sure, the labor market is a bit wobbly of late, but Bernanke himself noted some positive undercurrents, like an increase in hours worked and a drop in weekly claims; and yes, higher mortgage rates could slow the housing recovery. But most housing experts note that the recovery should remain in tact, thought the pace of price gains are likely to moderate.

Bernanke couldn’t say it, so I will: Congress is the biggest near-term risk to the U.S. economy.

 

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