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Virus, political risk, rising as Fed takes stock of post-election landscape

[November 02, 2020] By Howard Schneider

WASHINGTON (Reuters) - Over the past four years the U.S. Federal Reserve has navigated a global trade war, absorbed verbal blows from a volatile president, and confronted a once-in-a-century pandemic.

But any hope Tuesday's election will bring a new era of calm to U.S. central banking may be wishful in an economy still coping with massive unemployment, uncertainty about the course of a virulent disease, and perhaps a lengthy dispute ahead over who is running the country.

Indeed, as the Fed meets this week in the immediate shadow of Tuesday's election, some betting markets are forecasting as much as a 33% chance the race outcome won't be known by the time policymakers release their statement on Thursday afternoon. With markets priced for a clear Democratic Party victory along with an ambitious economic recovery program, anything short of that could touch off the sort of market disruption the Fed has tried to quell during the pandemic.

Prospects of a contested election, a rocky interregnum before the Jan. 20 inauguration, perhaps even a government shutdown if a new financing bill is not agreed in December, all make the coming weeks risky.

"A contested election. Awful payrolls. Halloween and Thanksgiving become superspreader events, and no leadership to deal with it. That is the scenario we all hope to avoid," said James Knightley, ING’s chief international economist, referring to the unemployment report due on Friday. Many economists expect it to show slowing job growth, and thus a deeper hole from the coronavirus recession.

READY THE REACTION FUNCTION?

In principle the Fed's virtual gathering on Wednesday and Thursday should be of little consequence, with policymakers repeating their now stock commitment to do what is needed to support a recovery.

After introducing a broad new strategy for monetary policy in August and backing that up in September with more detailed language about its plans, Chair Jerome Powell has said he felt their current policy statement was "durable" - unlikely to change much until recovery is largely complete.

That may still be the case. Economic data since their last meeting has been largely positive, with little to motivate any significant change.

"They got where they needed to get in September. So they stay very quiet," in the days following the election, said William English, former head of the Fed's monetary affairs division and a professor at the Yale School of Management.

What has changed since September is the virus, with daily case growth hitting records and some localities again imposing restrictions on commerce. And any sense of stability may be shattered by an unclear election result.

"A protracted, disruptive fight over who won the election would create significant market volatility" and tighter financial conditions at a time when the Fed aims to keep credit loose and flowing, said Cornerstone Macro economist Roberto Perli.

Though the Fed would likely view that as a short-lived problem, not something to shift its view of the economy or warrant major policy changes, a deep market dislocation could trigger its so-called "reaction function."

It "would be a relatively easy decision," Perli said, to ramp up the Fed's $120 billion in monthly bond purchases if financial markets react badly. It also has a full suite of emergency programs available, including swap lines with foreign central banks and open cash windows for financial markets.

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Federal Reserve Board Chairman Jerome Powell testifies during a Senate's Committee on Banking, Housing, and Urban Affairs hearing examining the quarterly CARES Act report to Congress, in Washington, DC, U.S., September 24, 2020. Drew Angerer/Pool via REUTERS

In a full blown electoral crisis, as in other tense moments, Powell's public comments at Thursday's press conference could also be used to try to calm any panic.

OTHER CHALLENGES

Beyond those immediate risks, the Fed faces other decisions as it approaches either a second term for President Donald Trump or a transition to a Democratic administration under former Vice President Joe Biden.

Most of the key emergency programs are due to expire on Dec. 31. Their lapse would test whether the financial plumbing can weather the pandemic without a central bank safety net. U.S. Treasury officials would have to agree to any extension, however, potentially putting a lame duck Trump administration in charge of buttressing the economy Biden would inherit.

Likewise, Tuesday's election may either clear the way for more emergency federal spending or muddy the waters further for those still struggling economically. That could be the trigger for a deepening recession alongside the worsening pandemic.

The clear Democratic victory anticipated by investors may bring its own set of challenges for the Fed: A large recovery program early next year might generate higher-than-anticipated inflation.

Indeed, inflation expectations have been rising since the Fed announced in August it would tolerate a faster pace of price increases. Goldman Sachs analysts estimate a "blue wave" Democratic victory would produce perhaps $2 trillion in additional fiscal spending, faster inflation, and force the Fed to raise interest rates perhaps as soon as 2023, two years sooner than otherwise anticipated.

But that's next year's problem.

Meanwhile, "there's a real risk we are in for some turbulent waters" in the weeks ahead, with millions of unemployed starting to lose benefits and possible political gridlock further delaying any renewal, said David Wilcox, former head of the Fed's research division and now a senior fellow at the Peterson Institute for International Economics.

"My real fear is that millions, possibly tens of millions of households, are coming to the end of their financial lifeline pretty much as we speak."

(Reporting by Howard Schneider; Editing by Dan Burns and Chizu Nomiyama)

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