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Three risks you didn't know about the Fed

Federal Reserve Board Chairman Ben Bernanke participates in a meeting of the Board of Governors at the Federal Reserve, October 24, 2013 in Washington DC.

Wednesday afternoon, the Fed will make an announcement, and investors will be watching to see if it tells the world when it will taper the large-scale bond purchases known as quantitative easing. The main worry about QE is that throwing all that money around would lead to inflation. So far, that hasn’t happened. But there are some lesser-known risks of QE.

If the Fed’s plan lifts the economy the way it hopes, interest rates will rise eventually. Higher interest rates drive down bond prices, including the Fed’s holdings.

“It means the Fed to a certain extent, bought high,” explains University of Wisconsin economist Ken West. “They’re buying high and selling low.”

That’s the exact opposite of what a good investor does. Odd as it sounds, the Fed stands to lose money selling bonds that it doesn’t hold to maturity.

Then there’s the impact on the market of the Fed’s deep dive into bonds. A program that gobbles up $85 billion in bonds every month will inevitably make waves in the securities market.

“Fed purchases have been substantial,” says Matt Slaughter, associate dean at Dartmouth’s Tuck School of Business. “One of the big open questions is from where inside the United States or abroad will creditors appear to buy that kind of debt in the future from the U.S. Treasury.”

There’s also the political risk of QE.

“Certainly if you’re at the Federal Reserve, you would like to implement your monetary policy without taking a lot of criticism from Congress,” says Hamilton College professor Ann Owen, a former Fed economist.

Even when less aggressive, the Fed has its critics. The most extreme don’t even think the central bank should exist. QE really riles up lawmakers who share that view. And they can make life complicated for the Fed.

Supporters of QE concede its risks, but say the benefits outweigh them.

“Caution always makes sense,” says Brookings Institution senior fellow and University of Michigan economics professor Justin Wolfers. “But this is not a reason not to do it, because not doing quantitative easing also means leaving millions of people unemployed.”

We’ll find out the Fed’s take soon enough.

Mark Garrison: If the Fed’s plan lifts the economy the way it hopes, interest rates will rise eventually. University of Wisconsin economist Ken West reminds us what that does to bond prices.

Ken West: The price of the securities goes down. It means the Fed to a certain extent, bought high. They’re buying high and selling low.

Yup, it’s the exact opposite of what a good investor does. Odd as it sounds, the Fed stands to lose money selling those bonds in the future. Then there’s the impact on the market of the Fed’s deep dive into bonds.

Matt Slaughter: Fed purchases have been substantial.

Dartmouth business school associate dean Matt Slaughter says you can’t stop gobbling up $85 billion in bonds every month without making waves.

Slaughter: One of the big open questions is from where inside the United States or abroad will creditors appear to buy that kind of debt in the future from the U.S. Treasury.

Then there’s the political risk of QE. Hamilton College professor Ann Owen is a former Fed economist.

Ann Owen: Certainly if you’re at the Federal Reserve, you would like to implement your monetary policy without taking a lot of criticism from Congress.

Even when less aggressive, the Fed has its critics. The most extreme don’t even think the central bank should exist. QE really riles up lawmakers with that view. And they can make life complicated for the Fed. Brookings Institution senior fellow Justin Wolfers concedes QE’s risks, but says the benefits outweigh them.

Justin Wolfers: Caution always makes sense. But this is not a reason not to do it, because not doing quantitative easing also means leaving millions of people unemployed.

We’ll find out the Fed’s take tomorrow. In New York, I'm Mark Garrison, for Marketplace.

About the author

Mark Garrison is a reporter for Marketplace and substitute host for the Marketplace Morning Report, based in New York.
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The FED is sort of a mind bender. We try to think of it like a business or a bank when, in point of fact, it is neither in the normal sense of the word. Take out your wallet and look at a dollar. It says "Federal Reserve Note". A note is a debt obligation. When the FED buys debt, it pays for it with its own debt. When sells debt back, it receives it's own debt back in return - not exactly like a business or a bank. The FED's purpose is to run a reliable payment system by facilitating bank transfers and maintain a balance between the money supply and the economy.

The real worry is on the Treasury side of the transaction where the Federal Budget is reliant on low interest rates to keep the government afloat. If banks begin to lend and rates go up to only 5%, the interest on the national debt will be $850 billion a year (20% of the Budget). That leaves the FED with the proverbial Hobson's choice - keep buying debt to keep interest rates low while risking serious inflation or sell debt to control inflation and risk blowing up the federal budget.

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