Federal Reserve prepares for U.S. default

As the wrangling over the U.S. debt ceiling continues in Washington, the Federal Reserve is making preparations in the event that Congress and President Obama fail to reach an agreement by the August 2 deadline.

August 2 is when the U.S. Treasury would run out of money to pay its bills if lawmakers cannot agree on a plan to raise the government’s $14.3 trillion borrowing limit.

"We are in contingency planning mode," Charles Plosser, president of the Philadelphia Federal Reserve Bank, told Reuters "We are all engaged. It's a very active process."

Plosser, a top Fed policymaker, said he thinks Obama and Congress will come to an agreement in time to avoid a default. Yet the Fed is developing procedures for how the Treasury would communicate to the Fed which government checks would get cleared and which wouldn’t. The policy would affect payments to everyone from social security recipients to government workers. Wall Street is also planning for the worst.

Last week Fed Chairman Ben Bernanke warned that a default would have catastrophic effects on the financial markets. Because of the continued bickering in Washington, the financial markets are already starting to become agitated, the New York Times reports. Stock prices have become increasingly volatile, although analysts say the signs of panic are small for now.

In Washington, Obama met separately with Republican and Democratic leaders Wednesday, yet neither reported significant progress on agreeing on a package that would include deep spending cuts, elimination of certain tax breaks and deductions and also lower some tax rates. The main sticking point is whether House Republicans would agree to any deficit-reduction plan that could potentially raise tax rates.

A number of high-ranking Republicans have already warned that the plan put forward Tuesday by the “Gang of Six” – a bipartisan group of senators who worked for months to reach an agreement – depended too much on higher revenues to cut projected deficits.