ST. LOUIS (Reuters) - Forget reverberations of Japan’s quake, high oil prices and Europe’s debt crisis. The biggest risk to the world economy currently is the U.S. government defaulting on its debt.
At least that’s how St. Louis Federal Reserve Bank President James Bullard sees it.
“The U.S. fiscal situation, if not handled correctly, could turn into a global macro shock,” Bullard said in an interview on Wednesday. “The idea that the U.S. could threaten to default is a dangerous one.”
It’s a hotly debated issue: Some Republican lawmakers think a brief U.S. default is acceptable if it forces the White House to deal with large budget deficits. Few Wall Street analysts believe it will come to that.
Bullard worries about reaction overseas if the U.S. government would technically default — basically delaying interest payments for a couple of days. That could happen in the absence of a political compromise on this year’s budget.
“If it were just U.S. markets, it might not cause too many problems, but we’ve got people participating in foreign markets who are probably not as tuned in to the U.S. political situation,” Bullard said. “The reverberations in those global markets would be very severe. That’s where the real risk comes in.”
On the economic home front, Bullard said the recent spate of weak U.S. jobs and other data that has spooked markets is likely to be a temporary blip. It could, however, cause the Fed to stay put for longer than expected after ending its current $600 billion round of bond-buying this month, he added.
The Fed’s policy-setting panel will want to weigh data at its August and September meetings before deciding on the timing of tightening, said Bullard, who does not have a vote on the committee this year.
“With the weaker data, it’s fine to tell the story that you think things are going to pick up, but then you are going to want to see some confirmation of that,” said Bullard, who oversaw research at the St. Louis Fed before becoming president in 2008.
Once fresh data confirms the economy is strengthening, he said, the Fed is likely to start tightening by ending its program of reinvesting bond proceeds.
“Our most likely move next will be to tighten, but tightening to me means first to allow the run-off on the balance sheet. I would even sell a few assets, but I’m not sure the committee is willing to go that way,” Bullard said, adding rate hikes would come later.
Could this exercise trigger a blood bath in the bond market, where benchmark 10-year yields recently dipped to below 3 percent to hit six-month lows? Not in Bullard’s mind.
The real risk is the “fiscal uncertainty cloud” and the potential debt U.S. default, said Bullard, who earlier this year also saw Japan, oil and Europe’s debt crisis as big risks. And he said he can’t do much about it.
“This is up to Congress,” he said. “Congress will bear responsibility”
Fitch Ratings on Wednesday said it believed an agreement would be reached but warned it would downgrade the U.S. sovereign ratings to “restricted default” if the government fails to make payments due in August, when the U.S. Treasury will run out of maneuvers to pay the government’s bills.
If there is a masterplan by Treasury on how to handle a technical default, Bullard is not keyed into it — yet.
“It’s not up to us, it’s up to the Treasury,” he said, adding that while his bank takes the lead in transactions with Treasury, it does not set policy.
“I don’t have any input, involvement in that policy, and it’s up to those guys to have that contingency plan laid out,” he said.
A decline in inflation expectations from the first quarter “takes some pressure off” the need to tighten quickly, said Bullard, a self-described north pole of inflation hawks who on Wednesday quipped: “You can’t get north of me on inflation.”
Oil prices, which Bullard sees as the biggest driver for inflation, have come down as the risk premium on Middle East unrest dissipates, he explained.
Growing up in the town of Forest Lake near Minneapolis in the 1970s, Bullard remembers inflation spikes and long lines at gas stations. But he only started digging into the subject during his doctorate in economics at Indiana University.
Bullard has been hammering home in speeches that the Fed’s standard “core” U.S. inflation measure currently understates real price increases because it excludes food and energy.
The European Central Bank and others use “headline” inflation, which includes everything, to guide interest rate policy. Over time, the two measures converge but in recent years headline inflation has outpaced core.
Is Bullard championing headline inflation just to underscore the Fed is in touch with real people? That’s been an issue since his New York colleague, William Dudley, used iPad pricing as an example of why inflation wasn’t so bad during a townhall meeting in March. Dudley got guffaws and responses like: “I can’t eat an iPad!”
Or is Bullard serious about the Fed adopting headline inflation as the standard gauge — and tying interest rate moves to a specific inflation target like the ECB does?
“It would help us in the current environment because we have a super easy monetary policy, and this creates some worries that maybe we’ll lose control of the situation, and end up with a lot of inflation,” he said. “But if you explicitly stated a target then you would assuage some of those fears.”
Reporting by Jack Reerink and Ann Saphir; Editing by Neil Stempleman