The Fed will taper and hike rates soon: Economists

Traders work the floor of the New York Stock Exchange.
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Turbulence on Wall Street will likely return when the Federal Reserve decides to hike interest rates, top U.S. economists said in a paper that warned the Fed's huge stimulus program could have harmful consequences.

The paper, released on Friday, focused on a financial market selloff in mid-2013 after Fed officials said they planned to trim monthly bond-buying.

The authors found mutual fund investors participated heavily in the selloff even though their market bets weren't made with a lot of borrowed money.

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This is important because policymakers sometimes weigh the chances of a financial crash by looking at the size of leveraged bets, which can be prone to swift reversals. The research highlights a perhaps under-appreciated risk for the Fed's plans to wind down its easy-money stimulus.

Will the weather put a stop to the Fed's taper?
Will the weather put a stop to the Fed's taper?

"Whenever the decision to tighten policy is made, then the instability seen in summer of 2013 is likely to reappear," wrote JPMorgan chief U.S. economist Michael Feroli, University of Chicago professor Anil Kashyap and two other well-respected economists.

Several Fed officials were present at the high-profile economics conference where the paper was presented, and two said the paper raised real concerns.

That said, the ideas highlighted by the paper already play into the Fed's current monitoring of financial risks, said Minneapolis Fed President Narayana Kocherlakota.

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Kocherlakota, who is a voting member on the Fed's rate-setting policy committee this year, has argued forcefully for monetary stimulus and said the U.S. economy remains so weak that the Fed still has another "two to three years" to mull financial stability risks.

"We don't need this theory to be able to make decisions in March of 2014,'' Kocherlakota said during a discussion of the paper.

'Not a free lunch'

The Fed in January started winding down five years of ultra-accommodative policies meant to fight the 2007-09 recession and foster a stronger recovery. That means an eventual end to trillions of dollars in bond buying and a policy of keeping overnight interest rates at zero.

(Read more: Kocherlakota on instability concerns)

The risk that all this easy money may have inflated asset price bubbles has stoked debate within the Fed over whether policymakers should stand ready to raise rates earlier than planned to snuff out those risks.

Fed Chair Janet Yellen, however, has said her inclination is that financial stability risks can be addressed primarily through regulatory tools.

In the paper, also co-authored by professors Hyun Song Shin of Princeton University and Kermit Schoenholtz of New York University, the economists concluded that the current policy stimulus ``is not a free lunch'' and can bring about disruptions when that accommodation is lifted.

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"Perhaps the domestic macroeconomic fallout from exit will be as gentle as was the impact from the 2013 'taper tantrum,'" they wrote. "However, such a benign outcome is not guaranteed."

Fed Governor Jeremy Stein, who also spoke at the conference, agreed that the behavior of asset managers needs careful watching. He flagged the rapid growth fixed-income funds and similar investment funds.

"It would be a mistake to be complacent about this phenomenon simply because such funds are unlevered," Stein said.

Daniel Tarullo, a Fed governor and its top bank regulator, said on Tuesday the central bank should not rule out using monetary policy to combat asset price bubbles that potentially threaten financial stability.

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The economists argued in their paper that the Fed's two key stimulus efforts, monthly bond buying and a pledge to keep interest rates low for a long time, "can build future hazards by encouraging certain types of risk-taking that are not easily reversed in a controlled manner."

The paper also underlines a concern that Tarullo and Stein have raised in the past: that regulatory tools may not be enough to stamp out risks in harder-to-detect corners of financial markets.

The usual tools of monitoring banks—bank capital ratios and liquidity requirements, among other regulations—fail to address instabilities that mutual fund investors, for example, can cause when they rush for the exits, the economists wrote.

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The 55-page paper examined bond flows from mutual funds, and noted that investors do not want to be the last out of a trade.

It finds that banks need not take action to spark market tantrums, suggesting that too-big-to-fail banks should not be the sole focus of regulators looking to stabilize markets.

The "absence of leverage may not be sufficient to ensure that monetary policy can disregard concerns for financial stability," the paper said.