What would the Fed do if the U.S. debt limit was default?

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What would the Fed do if the U.S. debt limit was default?

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 is an outcome the White House warned on Friday could plunge the economy into recession.

If the impasse in Congress over the $28.5 trillion debt limit wasn't resolved before an October deadline, what would the Federal Reserve do?

As it turns out, Fed Chair Jerome Powell may already have a strategy. The country faced a similar crisis over the debt limit in 2011 and again two years later, at an unscheduled October 2013 meeting - including Powell, who was then a Fed governor, and Yellen, who discussed possible actions in response.

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

In short, changes to the Fed's bank supervision were also planned. Banks would be allowed to count defaulted Treasuries against 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 give lenders legit to stressed borrowers.

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

They readily agreed to some measures, including offering continuing 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 which are not in default and buying ones that are.

Powell described these approaches as loathsome. The economics are very good, but you could step into this difficult political world and look 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 was then the San Francisco Fed president and is now the head of the New York Fed.