Forget reverberations of Japan's quake, high oil prices and Europe's debt crisis. The biggest risk to the world economy currently is the 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 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 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."
TIMING THE TIGHTENING
On the economic home front, Bullard said the recent spate of weak 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 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 sovereign ratings to "restricted default" if the government fails to make payments due in August, when the Treasury will run out of maneuvers to pay the government's bills.
