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.
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