Its Forecast Dim, Fed Vows to Keep Rates Near Zero

The Federal Reserve made a rare promise on Tuesday to hold short-term interest rates near zero through at least the middle of 2013, in a sign that it has all but written off the chances of an expansion strong enough to drive up wages and prices.

It is now conventional wisdom among forecasters that the economy will plod along through the end of President Obama’s first term in office. Millions of Americans will not find work. Wages will not rise substantially.

By its action, the Fed is declaring that it, too, sees little prospect of rapid growth and little risk of inflation. Its hope is that the showman’s gesture will spur investment and risk-taking by convincing markets that the cost of borrowing will not rise for at least two years.

The Fed’s statement, with its mix of grim tidings and welcome aid, contributed to wild market oscillations as investors struggled to make sense of the economy and the path ahead. The day ended in a huge upward surge on the New York Stock Exchange — the second busiest day this year after the record volume on Monday, during a deep sell-off — that could not be tallied completely until well after the markets had closed.

The Dow swung as much as 600 points in the wake of the Fed statement, at first sinking over 200 points. But after traders absorbed the decision, they quickly reversed course, and the Dow closed the day up 429 points, or 4 percent, to 11,239.77, as some investors expressed hope that the pledge to keep interest rates low could relieve some of the gloom over the economic outlook.

“The economy is in tough shape and the Fed had a difficult job of showing that they understood that without appearing to be alarmist,” said Steven Lear, who helps to manage a $150 billion fixed-income portfolio for J.P. Morgan Asset Management. “We think that they’ve played that hand about as well as they could.”

The policy announced Tuesday is an incremental step that economists described as unlikely to drive significant growth. The Fed already has held rates near zero since December 2008, and the economy is awash in cheap money. The great impediment, beyond the Fed’s easy reach, is the lack of demand from indebted consumers, nervous businesses and a shrinking public sector.

The Fed demurred, however, from taking stronger steps to aid the struggling economy, a decision that reflected deepening divisions on its policy-making committee, which generally tries to move only by unanimous consent. The vote to promise two more years of low rates passed by a margin of 7 to 3, the first time in almost 20 years that at least three members recorded votes in dissent.

The internal controversy parallels the broader debate in Washington between those pleading for the government to redouble its support for the faltering economy, and those who doubt the utility of additional aid and fear the consequences of the vast efforts already made. The three Fed members in dissent all have expressed concern that the central bank is not paying enough attention to inflation.

The Fed said in a statement that it would continue to consider additional measures to support the economy, but the split vote suggested that the Fed’s chairman, Ben S. Bernanke, may struggle to win sufficient support.

The statement, which includes an assessment of the economy, was a patchwork quilt of discouraging language. The labor market is deteriorating, construction is weak, housing depressed, recovery slow.

“Economic growth so far this year has been considerably slower than the committee had expected,” it said. “The committee now expects a somewhat slower pace of recovery over coming quarters.”

Twenty-five million Americans cannot find full-time work, a number the Fed said would decline “only gradually.”

The Fed is charged by Congress with minimizing unemployment, and increasingly vocal critics have questioned why the central bank is standing still even as the economy shows clear signs of faltering. The modest step announced Tuesday did not satisfy many of those critics.
“The Fed took the least action possible given the circumstances,” Sherry Cooper, chief economist at the BMO Financial Group, said in a note to clients. “Bottom Line: Holy Cow!”
In part, the Fed’s answer is that it is already engaged in an immense program of economic aid.

The central bank has held its benchmark short-term interest rate near zero for more than two years, flooding the financial system with the nearest thing to free money. It already had promised, most recently in June, that it would keep rates near zero “for an extended period” — at least several months, Mr. Bernanke said earlier this year.

The Fed also has amassed a portfolio of more than $2.5 trillion in Treasury securities and mortgage-backed securities, putting downward pressure on long-term interest rates. The purchases have pushed investors into the stock market and other riskier investments, and reduced the value of the dollar, helping American exporters.

The decision announced Tuesday is intended to put additional pressure on long-term interest rates, although not with the same direct force as buying $600 billion in securities, a program it completed in June. The rates on long-term securities reflect a combination of expectations about short-term rates and a risk premium for holding a long-term note. Buying bonds reduces that risk premium; by promising to keep rates low, the Fed aims to reduce expectations about future short-term rates.

The Fed’s statement stopped short of an absolute commitment to provide two years of near-zero rates, preserving some room for movement if economic conditions change drastically. But Vincent R. Reinhart, who headed the Fed’s monetary affairs division until 2007, said the meaning was clear.

“It’s as close to an unconditional commitment as you can get out of a central banker,” said Mr. Reinhart, now a scholar at the American Enterprise Institute. “It means that you’ve handcuffed yourself. You can’t change it. You’ve given up unless there’s an overwhelming case to offset inflation risk.”

A second reason for the Fed’s restraint, it is increasingly clear, is the opposition of a group of Fed officials who are concerned that the central bank is overly discounting the risk of inflation.

The three members who dissented from the majority Tuesday were Richard W. Fisher, president of the Federal Reserve Bank of Dallas; Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis; and Charles I. Plosser, president of the Federal Reserve Bank of Philadelphia.

By law the Fed is responsible for keeping prices steady and unemployment as low as possible. But Mr. Bernanke, like his predecessors, places greater emphasis on prices, in part because the Fed has concluded that slow, steady inflation — about 2 percent a year — is the best atmosphere for enduring job growth.

The Fed projected in June that inflation could reach 2.5 percent this year, a crucial reason for its announcement then that it would pause before considering new measures.

There are now signs that inflation is abating, as a temporary spike in commodity prices earlier this year works through the economy, and as growth weakens. Mr. Bernanke and his allies on the committee have predicted as much all year, and the announcement on Tuesday reflects confidence in that judgment.

But conservative members of the policy-making board see evidence in past recoveries that inflation can accelerate quickly, with little warning. Their dissents echo the last time the committee was as deeply divided, in November 1992, when three members pressed to begin raising the short-term interest rate, which then stood at 3 percent.

The Fed’s statement, indicating that it will continue to consider additional options despite those internal divisions, sets the stage for Mr. Bernanke’s speech later this month at a conference in Jackson Hole, Wyo. Last year, he used the opportunity to indicate that the Fed would undertake a new round of asset purchases. “The markets,” Mr. Lear said, “will be actively interested to hear what he says.”

Economy Grinds To Halt As Consumers Pull Back

Consumers all but shut their wallets in the second quarter, causing the U.S. economy to grow at a tepid pace.

To make matters worse, growth in the first quarter was much slower than initially thought, according to new government figures released Friday.

"It's quite worrisome as the economy remains at stall speed in the second quarter," said Sal Guatieri, senior economist with BMO Capital Markets. "If that continues, then it would raise the risks of a double dip."

Gross domestic product, the broadest measure of the nation's economic health, rose at an annual rate of 1.3% in the second quarter, the Commerce Department said.

While that's an increase from the revised 0.4% growth rate in the first three months of the year, it is hardly good news. The government originally reported that the economy grew at a 1.9% annualized rate in the first quarter.

The growth in the second quarter was also below the 1.8% increase expected by economists surveyed by CNNMoney.

Dubbed a "soft patch" by economists and even Federal Reserve Chairman Ben Bernanke, the economy's sluggishness was due to a variety of factors that weighed on consumers and businesses.

Higher gas prices for one, hit Americans hard when they peaked at a national average of $3.98 a gallon in May.

Top 10 consumer complaints

Overall, consumer spending, which accounts for roughly 70% of gross domestic product, picked up only 0.1% in the second quarter -- marking a significant slowdown from growth of 2.1% in the first three months of the year.

"The major disappointment in the report was the weakness in consumer spending, and it wasn't just fewer automobiles being sold due to Japan's earthquake. There was broad-based softness in consumer spending." Guatieri said.

It marked the slowest growth in consumer spending since the fourth quarter of 2009.

Looking back further, it also now appears that American consumers had less disposable income than originally thought from 2007 through 2010, whereas corporate profits were revised significantly higher for 2009 and 2010.

The government revised the GDP data back to 2003 and also found the recession was worse than originally thought.

Overall, the theme of the U.S. recovery continues to be one driven by companies holding cash on the sidelines and building up their infrastructure, rather than a recovery driven by consumers.

Americans on Main Street continue to be held back by slow job growth and the housing slump, even as major companies report strong profits and have mostly solid balance sheets.

Where the jobs are

According to the latest GDP report, investment in commercial real estate surged 8.1% in the

second quarter, and business spending on equipment and software rose 5.7%.

Meanwhile, exports rose 6%. The U.S. continues to import far more goods and services than it exports to foreign countries, but because imports grew at a slower rate of 1.3%, that also contributed positively to GDP.

The aftermath of Japan's earthquake and tsunami may have been one of the major reasons import growth slowed, as the U.S. bought fewer auto parts from the country.

Friday's GDP report also sparked cries from economists for lawmakers to act quickly in raising the debt ceiling and agree to a deal to cut the national deficit over the long term.

"We don't expect a recession, but if policymakers drag their feet -- which they are doing -- it will be a little more likely," said Paul Dales, senior U.S. Economist for Capital Economics.

Guatieri said: "If the government does not raise the debt ceiling and is forced to cut back spending and Social Security checks, that could undermine consumer spending even further."

U.S. debt downgrade trigger a financial crisis?

As we approach Treasury’s debt-ceiling deadline, attention has shifted from the risks of a default on Treasury debt to the risk of a downgrade of U.S. credit. Many are asking whether a downgrade could itself lead to a financial crisis. With the example of 2008 still fresh in many minds, the question has become: Would it be as bad as the Lehman Bros. bankruptcy?

Some market observers speculate that a downgrade would be a non-event: Japan, for example, went from a rating of AAA to AA without much drama. Others suggest that a downgrade would increase Treasury’s borrowing costs by $100 billion a year or more, making our already unsustainable deficit trajectory even worse.

There are no rules to define what is systemic and what isn’t — or to accurately predict the consequences of an economic shock. Each crisis is unique. How exactly it will affect financial markets, companies and our economy is impossible to know. Nonetheless, recent examples offer guidance.

In 2008, a number of once-cherished beliefs were turned upside down: (1) that home prices in America would never fall; (2) that AAA-rated subprime securities are sound; (3) that a major investment bank would never fail. Consumers, investors and companies allocated capital according to these truths. When the beliefs were revealed to be false, massive shocks were inflicted on the economy as financial markets rapidly adjusted to account for these new risks.

Banks had to reduce their leverage and rein in lending. Companies froze investment. Consumers cut spending and started saving. As a result, the economy plunged into recession, and millions of jobs were lost. Unemployment shot to 10 percent.

The question now is whether U.S. Treasury bonds, which anchor the global economy, really are the gold standard, the risk-free financial instruments they have been trusted to be. What will happen if that truth is revealed to be false?

Four factors in particular can help assess the magnitude of the financial impact from an undermined truth:

(1) How strongly is the belief held?

In 2008, investors around the world generally believed that major U.S. investment banks were so large they would never be allowed to fail. In the six months leading up to Lehman’s bankruptcy, however, it came under increased funding pressure and its stock price slowly collapsed. Markets were not completely convinced that the government would have the will or the ability to save Lehman; otherwise investors would have continued lending to it, as they did to Fannie Mae and Freddie Mac, which had no trouble borrowing money before they were rescued only days ahead of the Lehman bankruptcy.

By comparison, U.S. Treasurys have been defined for decades as the risk-free financial instrument throughout global financial markets. Faith in Treasurys is far stronger than it ever was in Lehman Bros. This suggests a far bigger shock than Lehman if this truth is proven false.

(2) How big an asset class does the belief support?

U.S. Treasurys are a $14 trillion market — the single biggest security market in the global economy. In comparison, Lehman had approximately $600 billion of liabilities before it failed, less than 5 percent of the size of the Treasury market. Treasurys are held by virtually all 8,000 banks in America and nearly all insurance companies, corporations, pension plans and millions of individuals’ 401(k)s. This scale suggests a far larger shock than Lehman.

(3) How wrong was the belief?

Here, Treasurys are not as bad as Lehman. Even if the U.S. credit rating is downgraded, almost no one believes we will actually default on our debt. The United States is not entering bankruptcy, and its debt is not junk. Lehman debt ultimately proved to be worth a fraction of its face value. To some, this suggests a U.S. downgrade would produce a more modest shock than Lehman. But a small deviation from a cherished belief can be as shocking as a large deviation from a weaker belief.

(4) What is the economic context in which the shock is taking place?

Although the United States is technically no longer in recession, the U.S. economy is growing slowly. Unemployment remains at 9.2 percent. Europe is awash in its own fiscal crisis, and much of the developed world is struggling. When Lehman collapsed, U.S. unemployment was at 6 percent, but the economy was contracting and housing markets were plummeting. The global economic context in September 2008 was probably worse than today, but our economy remains vulnerable.

These factors suggest that a U.S. downgrade has the potential to be as bad or perhaps worse than the Lehman shock. The more strongly held a belief, and the larger the asset class it supports, the greater the potential damage to the economy when the belief is turned upside down. We may not be certain what will happen if U.S. credit is downgraded, but there is no upside to finding out.

The writer, a managing director of the investment management firm Pimco, served as an assistant Treasury secretary during the George W. Bush administration. He established and led the Office of Financial Stability and the Troubled Assets Relief Program until May 2009.

Debt ceiling deadlock: Who will get paid?

That's the $14.3 trillion question as each day ticks closer to next week's debt ceiling deadline and Congress shows no sign of brokering a deal.

If lawmakers fail to raise the ceiling by Tuesday, the Treasury Department has said it will no longer be able to guarantee that it can pay all the country's bills in full and on time.

That's because Treasury will not be taking in enough revenue to cover all the bills coming due in August. And without a debt ceiling increase, it will be prohibited from borrowing new money in the bond market to make up the difference.

So, something will have to give.

The consensus thinking has been that Treasury will prioritize who to pay first and who to put off. And at the top of the list of who gets paid will be investors owed interest on U.S. debt. If the investors aren't paid, that would constitute a default, which would have a host of negative consequences for the country.

Of course, it's possible Treasury may decide it doesn't actually have the authority to prioritize and will instead pay interest owed to bond investors but pay other bills as they come due -- first come, first served, said former Treasury official Jay Powell, who coauthored a Bipartisan Policy Center report on the consequences of not raising the debt ceiling.

Assuming, however, that Treasury believes it has the authority to prioritize, it's not clear yet who will be paid first alongside investors. The Treasury has said it will provide more information as Tuesday approaches, and Republican Sen. Orrin Hatch has requested that the department turn over its plan by 5 p.m. on Thursday.

The plan, however, isn't likely to make anyone feel better.

Will I get my Social Security check?

That's because everyone to whom money is owed besides bond investors have either qualified for federal benefits, provided goods or services to the government, are serving in the military or otherwise work for Uncle Sam. Money will also be due to agencies to which Congress has legally appropriated money to run federal programs.

On deck to be paid every month: retirees, veterans, business owners, federal workers, active-duty soldiers, Medicare physicians and government agencies that need money to keep the lights on, to name just a few.

"While at midnight on August 2nd we don't all turn into pumpkins," White House spokesman Jay Carney said in a press briefing, he described the process of picking who to pay and who to put off as a "Sophie's choice."

How the math might work: The Bipartisan Policy Center estimates that Treasury will be short by about $134 billion for the month of August.

That cash deficit will build steadily throughout the month.

So, on Aug. 3, for instance, the center estimates that Treasury will take in $12 billion in revenue and have to pay out $32 billion, creating a $20 billion cash deficit. Among the biggest bills due that day: $23 billion for Social Security payments, $2.2 billion for Medicare and Medicaid payments, and $1.8 billion due to defense vendors.

On Aug. 4, the group estimates that the cash deficit will increase to $26 billion, with only $4 billion in revenue coming in, compared to $10 billion in bills, the largest of which would be for Medicaid and Medicare.

Come Aug. 5, the cash deficit grows another $5 billion to $31 billion.

By Aug. 15, the Bipartisan Policy Center estimates that the running cash deficit will hit $74
billion. That day the Treasury will take in an estimated $22 billion in revenue and have to pay out roughly $41 billion. The biggest bill that day is a $30 billion interest payment.

Cash on hand: What's not yet clear is how much cash Treasury might have on hand going into August.

The Bipartisan Policy Center estimates it might have enough, in theory, to pay bills in full until Aug. 10.

Even if that's right, however, Treasury may still decide to withhold some payments sooner to preserve cash to ensure it can make interest payments after Aug. 10.

It may also keep some cash on hand to ensure it can make principal payments on bonds coming due after Aug. 10.

Treasury will be able to hold bond auctions to roll over existing debt as it matures -- more than $450 billion is expected to come due in August.

However, if there isn't enough demand for Treasuries because of the uncertainty the political crisis in Washington has caused, those auctions may fail to raise all that Treasury needs to pay the principal due.

So Uncle Sam would have to pony up using the revenue coming in. That would mean even less money available to pay seniors, vets, small business owners and others who are part of the lifeblood of the U.S. economy.

USA Senate Offers $3.75 Trillion Deficit Cuts

A bipartisan group of U.S. senators on Tuesday revived an ambitious budget plan that could provide new ideas for breaking the impasse in Congress over raising the nation's credit limit by August 2.

President Barack Obama threw his support behind the proposal by the "Gang of Six" senators, saying it was broadly consistent with his approach on reducing debt and deficits.

Obama urged Senate Majority Leader Harry Reid, a fellow Democrat, and Senate Republican leader Mitch McConnell to start "talking turkey" about it.

Senate Budget Committee Chairman Kent Conrad, one of the six Democratic and Republican senators who have been working since December on a deficit-reduction plan, said the proposed $3.75 trillion in savings over 10 years contains $1.2 trillion in new revenues.

The group briefed about half of the 100-member Senate and "the response was very favorable," Conrad told reporters.

He said the group asked fellow senators to take 24 hours to look at the proposal and "report back to us."

According to an executive summary of the plan, it would immediately impose $500 billion in deficit cuts, cut security and non-security spending over 10 years with spending caps, make the Medicare and Medicaid healthcare programs operate more efficiently and abolish the Alternative Minimum Tax.

Asked whether the plan could become part of urgent negotiations that link deficit reduction to raising the U.S. government's borrowing authority by August 2, Conrad said: "Could the two get married? Could they get combined at some point? I'm sure that's possible."

But leaders must first find out whether the proposal has enough support in the Senate, he said.

But a senior Senate Democratic aide said, for now, "there are no discussions" on incorporating Gang of Six ideas into legislation to raise the debt limit beyond $14.3 trillion.

TAXES AT ISSUE

Conrad was quick to say that while there are $1.2 trillion in new revenues, the overall plan envisions a $1.5 trillion tax cut that would be achieved through broad tax reforms.

Most Republicans, especially Tea Party members in the House of Representatives, have vowed to block any revenue increases.

The Senate group's hope has been that if the three conservative Republican members embrace revenue increases, the idea could catch fire among other Republicans in the Senate and House -- especially if popular but expensive entitlement programs such as Medicare also shoulder some cuts.

In another politically risky move, the Gang of Six plan would achieve significant savings in healthcare programs, Conrad said. The specific spending cuts would be decided later by congressional committees.

Conrad said a separate measure would reform the Social Security retirement program to stabilize its finances for the next 75 years.

The effort got a boost as conservative Republican Senator Tom Coburn rejoined the group after taking a "sabbatical" in mid-May amid heavy disagreement over Medicare spending cuts. It was not yet clear how Coburn's concerns have since been addressed.

On Monday, Coburn unveiled his own plan to cut $9 trillion in deficits over a decade, including nearly $1 trillion in revenue increases.

Revenue proposals are not likely to include income tax rate increases. Instead, they could center on repealing or rolling back special tax favors such as those for ethanol blenders and companies that operate corporate jets, as well as preferential tax treatment for fund managers.

Those specific decisions likely would be up to House and Senate tax-writing committees, along with broader tax reform questions.

Beware the debt ceiling vote

The debt ceiling talks, for weeks now, have been going on behind closed doors. The negotiations have been conducted by a tiny group of legislative leaders and President Obama's top aides.
All the while, the countdown to Aug. 2, when the government will no longer be able to pay all its bills, has marched closer.

Any proposal will still have to be put into legislative language, scored by the Congressional Budget Office and vetted by rank-and-file lawmakers whose votes will decide its fate.

Even after the principal negotiators announce a deal, the rest of Congress will have to be convinced to go along. The closer to D-Day Washington gets, the messier it will be.

Witness what happened on Sept. 29, 2008, when the House at first rejected the $700 billion bank bailout bill.

Weeks earlier, Fannie Mae and Freddie Mac had been placed into conservatorship by the Treasury Department. Lehman Brothers had filed for bankruptcy. AIG Corp, the world's biggest insurer, had been bailed out by the Federal Reserve.

After all that, the Senate passed the bill. And then, as markets watched, the measure was voted down in the House -- a defeat that shocked investors and congressional leaders on both sides of the aisle.

Debt ceiling: What happens if Congress doesn't raise it?

Following the vote, the Dow slumped 778 points, in the biggest single-day point loss ever.
A few days later, the House reversed course and passed a modified version of the bill. Some 58 members switched their votes.

Why was the process so hard? A principal reason is that it was rushed.

Lawmakers who voted against the bill warned that "being stampeded" into a decision would be a serious mistake.

"Wall Street is so hungry for the $700 billion they can taste it. To get it they need to ... create panic, block alternatives and herd the cattle. We ask Congress not to rush," California Democrat

Rep. Brad Sherman said before the vote.

"I am voting against this today because it's not the best bill. It's the quickest bill," Rep. Marilyn Musgrave, Republican of Colorado, told the New York Times. "Taxpayers for generations will pay for our haste and there is no guarantee that they will ever see the benefits."

Norman Ornstein, a resident scholar at the American Enterprise Institute, said lawmakers now face a similar situation, but this time around, "It's worse."

Lawmakers aren't going to have a lot of time to consider their options. And all the negotiations are happening behind closed doors, limiting the involvement of rank-and-file members.

"With TARP, it wasn't clear that another day or two wouldn't make a big difference," Ornstein said. "If you take two to three days messing around with this, you end up with what could be a profound and very long lasting impact."

The White House has already warned that time is running short, saying that a deal needs to be completed in the next couple days in order to give Congress time to pass a bill.

Alabama Republican Sen. Jeff Sessions has voiced concern about the timeline, saying there is a "very real risk that no text will be available until the last minute" and that a bare minimum of seven days is needed to review legislation.

How Washington screwed up the budget

"The real endgame here is not August 2," Ornstein said. "It takes time to put any agreement into legislative language and get it scored. It sure as hell doesn't look to me like we are urgently moving to make sure that happens."

And like 2008, not everyone is dealing with the same set of facts. At that time, every high-ranking government official from then-President Bush on down was warning of dire consequences if TARP faltered in the House.

That moved a few members into the "yes" column, but not all.

"We're on the cusp of a complete catastrophic credit meltdown. There is no liquidity in the market," Rep. Sue Myrick, a North Carolina Republican, said in a statement before the vote. "We are out of time. Either you believe that fact, or you don't. I do."

Right now, despite warnings from Treasury Secretary Tim Geithner, President Obama, Federal Reserve Chairman Ben Bernanke and even House Speaker John Boehner, a number of Republicans remain so-called debt ceiling deniers.

"You've got enough people out there, way too many people, who aren't going to be convinced until Armageddon actually happens," Ornstein said.

Gang Of SIX Plan Offers Hope

With just two weeks left until the federal government runs out of money to pay all of its bills, President Barack Obama seized on the "Gang of Six" plan as a "very significant step" and urged congressional leaders to start discussing it.

"My hope ... is that they tomorrow are prepared to start talking turkey and actually getting down to the hard business of crafting a plan that can move this forward in time for the August 2nd deadline," Obama said.

The U.S. government will default on its obligations by that date if Congress does not allow the Treasury to sell more debt. That could force the U.S. economy back into recession and wreak havoc on global financial markets.

White House talks on a comprehensive deficit reduction deal have stalled over tax increases, which Republicans oppose. Obama, a Democrat, said he hoped the "Gang of Six" proposal -- which would require each party to ease back from entrenched positions -- could help form the basis of an agreement.

A broad deficit reduction package would clear the way for Congress to approve an increase in the $14.3 trillion federal debt ceiling. A backup plan by Senate Republican leader Mitch McConnell has gained momentum as a way to raise the ceiling and may end up incorporating parts of the "Gang of Six" proposal.

Senate Budget Committee Chairman Kent Conrad, one of the six Democratic and Republican senators who have been working since December on a deficit reduction plan, said the proposed $3.75 trillion in savings over 10 years contains $1.2 trillion in new revenues.

'11TH HOUR'

Obama's decision to speak to reporters about the "Gang of Six" plan even before he had fully read it showed the sense of crisis that is enveloping Washington as the clock ticks toward the August deadline.

"The problem we have now is we're in the 11th hour and we don't have a lot more time left," the president said.

The stalemate on debt talks has shaken global markets and credit rating agencies have warned they might downgrade the U.S. top-notch AAA rating if lawmakers do not agree on a broad-based deficit reduction plan.

A $3.75 trillion budget cut plan would exceed market expectations, said RBS Securities Treasury strategist John Briggs in Stamford, Connecticut.

News of the "Gang of Six" plan sent prices of 30-year U.S. bonds sharply higher and helped push U.S. stocks to their best day since March.

The plan quickly won support from many senators, including some conservative Republicans, and was rapidly gaining traction despite the fact it includes tax increases. Republican Senator Roger Wicker said it could pass the 100-seat Senate with a healthy majority of 60 or 70 votes.

But some aides urged caution, saying even if the plan proves popular in the Senate, there may not be time to craft it into detailed legislative language and then have it assessed by the Congressional Budget Office -- a necessary step -- before August 2.

Speaker of the House of Representatives John Boehner, the top Republican in Congress, has some concerns with the "Gang of Six" proposal, his spokesman Michael Steel said, adding the plan falls short in "some important areas."

BACKUP PLAN STILL BEING CONSIDERED

The "Gang of Six" plan came as White House and congressional negotiators worked on the premise that the only viable political solution to avoid default might be the backup plan proposed by McConnell.

His plan would hand Obama the authority -- and the blame -- for raising the $14.3 trillion debt ceiling. Democratic Senate Leader Harry Reid has proposed changes to make it attractive to Democrats, including up to $1.5 trillion in spending cuts.

"If there ... we can improve upon the legislation that we are doing, I am happy to take elements of the Gang of Six and work with them to get that done," Reid said.

Reid said he would like to begin consideration of the backup plan as soon as possible. Aides said that likely would not be until Saturday due to procedural hurdles.

The No. 2 Republican in the Senate, Jon Kyl, said he expects the McConnell plan to be approved in the Senate.

Obama said the backup plan was an important fallback in case lawmakers cannot agree on a broad deficit reduction plan.

Moody's Investors Service analyst Steven Hess said the McConnell/Reid plan would avoid any immediate downgrade of the coveted AAA rating.

But he said the plan did not offer a big enough deficit reduction and could result in a negative outlook on the rating, a sign of a possible downgrade in 12 to 18 months.

In the Republican-controlled House, a vote was expected on Tuesday on a deficit-reduction plan that would drastically cut and cap spending and require an amendment to the Constitution requiring a balanced budget. Obama said he would veto it.

The vote is largely symbolic as the measure is unlikely to pass the Democratic-controlled Senate. But it gives Republicans a chance to argue the need for deep spending cuts.

That could give Boehner, loathe to see Republicans blamed for a debt default, political cover to pursue a deal including less dramatic spending cuts than his party has so far sought.

U.S. Warned of Possible Downgrade

U.S. lawmakers got another stern warning from a leading credit rating agency on Thursday that there is now a very real possibility that the country's top-notch credit rating could be downgraded in the next three months.

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Standard & Poors said in a statement it was placing the United States' sovereign rating on "CreditWatch with negative implications."

"[O]wing to the dynamics of the political debate on the debt ceiling, there is at least a one-in-two likelihood that we could lower the long-term rating on the U.S. within the next 90 days," the agency said in a statement.

The action on Thursday follows a move in April when S&P changed its outlook on the U.S. AAA rating to "negative" because at the time it couldn't see how lawmakers would create a path to real debt reduction.

Bernanke: Debt ceiling breach 'calamitous'

Since then "the political debate about the U.S.' fiscal stance and the related issue of the U.S. government debt ceiling has, in our view, only become more entangled," the agency said.

"[W]e believe there is an increasing risk of a substantial policy stalemate enduring beyond any near-term agreement to raise the debt ceiling," S&P noted.

Indeed, other warnings from ratings agencies Moody's and Fitch in the interim spurred more rhetoric than action from politicians. Seven weeks' worth of talks between the parties led by Vice President Joe Biden broke down in June after House Majority Leader Eric Cantor left the negotiations.

And regular meetings at the White House between President Obama and Capitol Hill brass over the past two weeks have showed no signs of real progress. Obama will hold a press conference Friday to offer an update on the negotiations.

A downgrade of U.S. credit would mean interest rates on U.S. bonds would go up. And it could have ramifications across global markets because U.S. bonds are considered the world's safe haven investment.

The Treasury issued an immediate response to the news.

"Today's action by S&P restates what the Obama Administration has said for some time: That Congress must act expeditiously to avoid defaulting on the country's obligations and to enact a credible deficit reduction plan that commands bipartisan support," Treasury official Jeffrey Goldstein said. (Read: Republican stance on taxes a bust with public)

A downgrade could come for one of three reasons, S&P explained:

-- If Congress and the administration fail to come up with a "credible solution" to U.S. debt and show no signs of agreeing on one in the foreseeable future.

-- If the United States misses any scheduled debt service payments, in which case S&P would issue a "selective default" meaning a default has occurred on some bonds but not others.

-- If S&P concludes that the debt ceiling debate so bogs down that it calls into question policymakers' "willingness and ability to timely honor the U.S.' scheduled debt obligations."

Treasury started sending letters to Congress back in January urging them to raise the $14.3 trillion debt ceiling -- which is the U.S. legal borrowing limit

The Treasury takes in, on average, about $125 billion less than it has to pay out on a monthly basis. To make up the difference it issues U.S. bonds, and because of the country's sterling rating, it is able to do so at very low rates.

If Congress doesn't raise the debt ceiling by Aug. 2, the Treasury will no longer be able to pay all of the country's bills in full and on time without interruption

Debt ceiling delay would be 'chaotic'

Here's what Americans can look forward to if lawmakers fail to raise the debt ceiling in time: Treasury would not be able to pay between 40% and 45% of the 80 million payments it needs to make every month.

That's the estimate from a new analysis by the Bipartisan Policy Center, a think tank in Washington founded by four former Democratic and Republican Senate majority leaders.

A delay in raising the debt ceiling could affect Social Security checks, food stamps, federal worker and military paychecks, government contractor bills and payments to Medicare and Medicaid providers.

"Handling all payments for important and popular programs (e.g., Social Security, Medicare, Medicaid, defense, active duty pay) will quickly become impossible," the report's authors noted.

Treasury Secretary Tim Geithner has said that by Aug. 2 he will no longer have enough money on hand every day to pay all the government's bills in full and on time. The government reached the legal borrowing limit on May 16 and has been taking "extraordinary measures" since to keep the country out of default.

To ensure it has enough cash on hand to make a $29 billion interest payment to investors on Aug. 15 -- among other payments -- the government would have to defer 44% of federal spending, and that would affect the broader economy, according to the BPC study.

Treasury is expected to update its estimate of the so-called "drop dead date" at the start of July, but no one expects the date to change much.

It's impossible for anyone to know exactly how much the government will take in and have to pay out on any given day in August. The BPC based its estimates on the revenue and outlays reported by Treasury from August 2009 and August 2010.

Bond experts to Congress: Don't mess it up

It's also impossible to say yet just how the government would prioritize payments. It's fair to assume, however, that picking who gets paid and who gets put off will be a mess technically and socially because it's never been done before.

"The reality would be chaotic," the report states.

The going assumption is that Geithner will do everything he canto pay bond investors, so the country doesn't go into a formal default.

"The Treasury Secretary will squirrel away money like -- well, a squirrel. He may have to delay some payments starting days or weeks early to prepare for big important payments later," said Joe Minarik, who served as the chief economist of the White House Budget Office in the Clinton administration.

And as the BPC study noted, the whole event could cause a public uproar and market unrest, the outcomes of which is anyone's gues.

California Budger with Deep Cuts

California lawmakers approved a $86 billion budget late Tuesday that imposes deep spending cuts but does not extend tax hikes.

The budget is a disappointment for Governor Jerry Brown, a Democrat who spent months trying to convince Republican legislators to put an extension of personal income and sales tax increases before the voters.

Unable to do so, Brown and Democratic legislative leaders cobbled together a plan that calls for a total of $14.6 billion in cuts.

"Putting our state on a sound and sustainable fiscal footing still requires much work, but we have now taken a huge step forward," Brown said in a statement.

Much of the bloodletting was agreed to in March, but this week's deal would add at least $2.5 billion in additional reductions.

Overall the Department of Health and Human Services would be slashed by $5 billion, while the Department of Corrections and Rehabilitation would see a cut of $1 billion. The state's two university systems would each lose $650 million in funding.

The budget hinges on the state bringing in $4 billion in more in tax revenues in the coming year than was initially expected. The improving economy has pushed the state's tax collections billions of dollars above estimates in recent months. Brown expects the windfall to continue into fiscal 2012, which starts Friday.

If tax revenue comes in lower than expected, the budget also would impose an additional $2.6 billion in cuts to higher education, corrections and in-home support services for the elderly and disabled.

The proposal would slash billions in spending for children, the sick, and the elderly, said Senate President pro Tem Darrell Steinberg. And it would hurt the state's economy, he said.

"This budget is the most austere fiscal blueprint California has seen in a generation," Steinberg said.

Since the budget does not call for tax increases, it requires only a majority of the Democratic-led legislature to approve it. However, Governor Brown and his fellow Democrats said they plan to put a tax measure on the ballot in November 2012 through a voter initiative -- bypassing the requirement for Republican consent.

Though they fended off Brown's tax extensions, Republicans immediately attacked the proposal, saying California needs a budget that will revitalize the economy and create jobs.

"This latest budget is based on the hope that $4 billion in new revenues will miraculously materialize, but does absolutely nothing to change government as usual," said Senate Republican Leader Bob Dutton.

The proposal is a major shift for Brown, who has said for months that the state's $26 billion budget's gap should be addressed with a mix of spending cuts and tax extensions. He also was determined to fulfill his pledge to put the extension of personal income and sales taxes before the voters.

However, he could not convince four Republicans to join him so he could get the measure on the ballot. A budget containing a tax hike needs the support of two-thirds of lawmakers.

Republicans have refused to go along unless the budget also contained a spending cap, as well as pension and regulatory reform.

The latest proposal was put together less than two weeks after Brown vetoed a budget approved by the legislature, saying it was chock full of gimmicks and contained legally questionable maneuvers.

California lawmakers lose pay until they pass balanced budget

Lawmakers had raced to pass a spending plan by June 15 to meet a voter-imposed deadline that required the legislature to pass a balanced budget or forfeit their pay.

However, state controller John Chiang determined that the budget was actually unbalanced. So lawmakers, who earn $95,291 a year and $142 per diem for each day they are in session, have gone without pay since mid-month.

Congress moves forward on free trade deals

The Senate will officially take up three trade deals and a scaled-back version of a jobs retraining program for laid-off workers on Thursday.

Senate negotiators will have to start pounding out the details of the trade deals, as well as

funding for the jobs retraining program -- whose funding ran dry in February.

"This was truly a bipartisan negotiation on all sides ... we think this is a strong package that reflected the different priorities," said one senior administration official on a call with reporters Tuesday.

But final passage on all the measures is not a done deal. Republican support depends on how closely the trade deals and jobs retraining program are linked together.

Republicans want to vote on the trade pacts, and have agreed to consider the new compromise that would extend the jobs retraining program, according to congressional aides. But they refuse to have the issues stuck together on the same bill, in a way that would prevent them from making changes to the jobs retraining program.

"I would strongly urge the Administration to re-think this action, and urge them to send up all three pending trade agreements without delay -- and without extraneous poison pills included," said Senate Minority Leader Mitch McConnell in a statement Tuesday.

If Congress were to pass the trade pacts without the jobs retraining program, President Obama would face a tough choice as he had previously said he couldn't have one without the other.

At issue is the Trade Adjustment Assistance program, which got a big funding boost with the 2009 economic Recovery Act.

The program gives unemployed workers financial help and job training when employers move jobs overseas. White House officials had previously said that more than 435,000 workers would be eligible for the program if it were reinstated. But Republicans have said they are concerned about funding such stimulus programs, because of the big deficits the nation faces.

A White House official outlined a compromise made on the program, saying it would be scaled back. He added that it wouldn't add to the deficit, thanks to cuts in unemployment insurance; and due to a new proposal that would penalize tax preparers who have "bad records," claiming tax credits for those who don't qualify.

But the White House couldn't give a final tab on Tuesday for the scaled back Trade Adjustment Assistance program.

An additional roadblock is that even though House Ways and Means Chairman Rep. David Camp was involved in the compromise, it's unclear whether even a scaled-back version could pass the GOP-controlled House

"We're pleased the President may finally send us the three job-creating trade agreements we've requested, but we have long said that TAA -- even this scaled-back version -- should be dealt with separately from the trade agreements," said Brendan Buck, spokesman for House Speaker John Boehner.

The one thing many congressional Republicans and Democrats can agree on is wanting to pass the trade deals to help boost the U.S. economy, particularly since some say the treaties could add as many as 250,000 jobs.

Despite Obama's effort to tie the trade pacts to something the unions want, the AFL-CIO and other labor groups continue to oppose the treaties -- which they say don't do enough to protect workers' rights.

But business groups from the U.S. Chamber of Commerce to the Business Roundtable applauded the move forward.

"With our economic recovery stalling, the time is now for Congress to act on these deals," said Thomas J. Donohue, president and CEO of the U.S. Chamber. "We simply cannot afford to put American jobs at risk any longer."

Fed set to buy $300B more Treasuries

QE2 is just about done. But the Federal Reserve will still be buying massive amounts of long-term Treasuries.

In fact, the Fed's purchases over the next year will likely be at least $300 billion. That's half the size of QE2 -- even if QE3 never takes place.

While the Fed's efforts to pump about $600 billion of new cash into the economy over the last eight months comes to an end this week, the program, known as quantitative easing or QE2 for short, was not the only way the central bank was an active buyer of Treasuries.

Since last August, the Fed purchased $250 billion in long-term Treasuries in addition to the QE2 purchases. That's because it was reinvesting the principal from other securities that matured.

Assuming the Fed keeps reinvesting, as it said it would earlier this month, it will continue to be a very big buyer of bonds in the months to come.

"We still see the Fed being a major buyer of Treasuries, and giving the market some support," said Kim Rupert, managing director of fixed income for Action Economics.

But those purchases may not push yields, which move in the opposite direction of their price, lower for that much longer.

Rupert said she expects bond yields to rise even with the Fed's continued purchases. She said some investors who bought Treasuries recently in a flight to quality will unwind those positions. If the economic outlook improves later in the year, that could also lift interest rates.

The additional Fed purchases will have an impact though. Rupert said it should "slow the updraft in yields in a measurable way."

The Fed still has more than $1 trillion in mortgage-backed securities, debt issued by government-sponsored firms Fannie Mae and Freddie Mac and other long-term bonds on its balance sheet.

While not all of this debt is set to mature in the next few months, the Fed still has a lot at its disposal to roll over into new bond purchases.

Of course the Fed could decide to stop reinvesting the principal of maturing securities. But that could almost have the same effect of actually raising interest rates. It would take significant amounts of cash out of the economy.

Even though some Fed policymakers are worried about the impact the bond buying has had on the dollar and inflation, the Fed does not seem ready to remove all its stimulus just yet. After all, the central bank did just issue a gloomier forecast for growth and unemployment through the end of 2012.

"Most of us can agree the economy is not going gangbusters and it's not a self-sustaining recovery yet," said David Coard, director of fixed income sales and trading for The Williams Capital Group. "For the foreseeable future, the Fed will have to maintain an accommodative stance. It's the only game in town."

Stocks don't need (or want) more stimulus

The Federal Reserve is winding down its $600 billion bond buying stimulus that helped fuel an eight-month stock rally, and experts say stocks are ready to take back the reins.

They don't need or want any more stimulus, say strategists surveyed by CNNMoney.

Even though stocks have retreated about 7% since the start of May, most market strategists say the pullback is temporary, and are calling for the S&P 500 to rise more than 7% during the second half.

That means the S&P 500 would end 2011 with double-digit gains ... at a fresh 3-year high. All of that without any additional stimulus.

"The Fed should stop. They've done more than enough already," said Matt King, chief investment officer at Bell Investment Advisors. "Any further stimulus only increases the long-term risk of inflation, which we already view as high."

A stormy year for stocks

What's more, some went so far to say that the Fed's stimulus program, known as quantitative easing or QE2, was "a failure."

"It weakened the dollar and stuck the economy with higher food and energy prices," said Donald Selkin, chief market strategist at National Securities, adding that those factors are to blame for the recent pullback in consumer spending and slowdown in economic growth.

CNNMoney survey: Where the markets are headed

Rather than another round of monetary stimulus, experts say policymakers need to focus their goals on righting the nation's fiscal ship to keep the market and economy on track.

"The Fed should move to the sidelines until Congress acts to extend the debt ceiling and addresses a budget deficit package," said Marc Pado, chief investment strategist at Cantor Fitzgerald.

Without Fed intervention, Congress may also be more inclined to address tax policies that are keeping record amounts of corporate cash abroad, experts said.

If Congress were to enact some sort of repatriation tax holiday, it could bring some of that money back to the United States, which would spur business spending and lead to more job creation.

"The Fed needs to pass the baton to the next runner in this relay race and that is business spending," said Burt White, chief investment officer at LPL Financial. "It is time for businesses to spend and hire, which will move the baton later to the anchor runner, the consumer."