Mendoza School of Business

The risks of more Federal Reserve action

Published: July 26, 2012 / Author: Annalyn Censky

The following is an excerpt from a CNN Money article that quotes Finance Professor Jeff Bergstrand on how another stimulus could affect the bond market. To read the entire article visit: The risks of more Federal Reserve action

Last week, Federal Reserve Chairman Ben Bernanke told lawmakers that the Fed stands ready to give the economy a boost, should the recovery continue to struggle.

But it’s unclear just how effective any further economic stimulus would be. Interest rates are already at record lows, yet hiring is tepid and consumer spending is still weak.

Plus, any additional stimulus would come with some risks.


Risk #3: Bond market mayhem

One of the most common next steps discussed by Fed officials, is for the central bank to initiate a third round of large-scale asset purchases, known as quantitative easing or QE3.

The program could come in the form of buying more Treasuries, mortgage-backed securities or some combination of both.

The Fed itself has admitted that buying Treasuries comes with some dangers. The central bank already has a large presence in the bond market, accounting for $1.7 trillion in Treasuries. (In comparison, China owns about $1.2 trillion in Treasuries, and Japan owns about $1.1 trillion.)

As the Fed buys more bonds, economists are unsure of how the central bank will ever be able to wind down those purchases. It’s possible the uncertainty could scare off other large bond buyers, like China and Japan, said Jeffrey Bergstrand, finance professor at the University of Notre Dame and a former Federal Reserve economist.

Should interest rates rise rapidly later, those foreign buyers stand much too lose on their investments.

“The Fed has this huge balance sheet and they don’t quite know how to unwind all those securities down the road. That creates an uncertainty to foreign central banks and investors that are holding any kind of instrument with a U.S. label on it,” said Bergstrand. “You never know when China and Japan are going to say ‘we don’t want to hold this stuff’ and those things can turn on a dime.”


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