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."
Some Republican lawmakers have said a brief U.S. default might be acceptable if it forces the White House to deal with large budget deficits, but few Wall Street analysts believe it will come to that.
However, Bullard is worried 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."
TEMPORARY ECONOMIC WEAKNESS
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 a monetary policy 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.
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." Oil prices, which Bullard sees as the biggest driver for inflation, have come down as a risk premium stemming from unrest in the Middle East has dissipated, he explained.
Once enough data comes in to confirm the economy is strengthening, he said, the Fed is likely to start tightening by ending its program of reinvesting bond proceeds.
Could that trigger a blood bath in the bond market, where benchmark 10-year yields recently dipped below 3 percent to reach six-month lows? Not in Bullard's mind.
The real risk is the "fiscal uncertainty cloud" and the potential U.S. debt 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 the fiscal crisis.
"This is up to Congress," he said. "Congress will bear responsibility."
Fitch Ratings on Wednesday said it believed a debt limit 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 Treasury has warned it will run out of maneuvers to pay the government's bills.
If there is a masterplan by the U.S. 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 the 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.
© 2017 Thomson/Reuters. All rights reserved.