Could Fed's QE Spiral Out of Control?

Traders work in the ten-year U.S. Treasury Note options pit at the Chicago Board of Trade in Chicago, Illinois, U.S.
Daniel Acker | Bloomberg | Getty Images
Traders work in the ten-year U.S. Treasury Note options pit at the Chicago Board of Trade in Chicago, Illinois, U.S.

The Federal Reserve said this week that it plans to buy $40 billion of mortgage-backed securities each month until the labor market improves.

But it's possible that the Fed might wind up having to buy far more than it plans.

(Read more: Fed's 'QE Infinity': Four Things That Could Go Wrong)

Let's say that the Fed's policy has the desired effect of bringing down mortgage rates. Lower rates typically trigger waves of refinancing, although that hasn't happened recently because of high unemployment and falling home prices. But home prices have stopped falling in most the country, and lower rates could encourage new home buying, further propping up prices. If the Fed is right about its program, unemployment should come down too. So maybe this time we will get a refinancing wave.

Refinancing doesn't necessarily increase the total amount of mortgage debt outstanding (unless homeowners are withdrawing equity). But it does increase the amount of current mortgage debt and therefore can increase the amount of production of mortgage-backed securities.

If supply grows more rapidly than expected, prices of the securities could fall. In order to support the prices, the Fed would have to buy ever bigger amounts. This could become a dangerous spiral, in which the Fed has to continuously raise the amount of securities it is purchasing just to keep up with the new supply.

Exiting this could be tricky. If the Fed stopped buying mortgages suddenly, or even just declined to raise its purchases to cope with the new supply, investors in the securities could find themselves saddled with unexpected losses.

This didn't happen with the earlier round of quantitative easing, so perhaps it won't happen this time. But, at the very least, I hope someone at the Fed is aware of the QE danger.

- by senior editor John Carney

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