What the Fed's Historic Bet Means for You

QE3 is an unprecedented experiment that might help jump-start the economy. But it could also hurt retirees, distort financial markets, and make your groceries more expensive. 

Don't ask me why but, since the Federal Reserve's dramatic policy announcement a couple of weeks ago, I have gotten repeatedly stopped -- in airports, in the grocery store, and on the street -- by people wondering what the Fed decision means for them. The answer is: it's a mixed bag

Those of you with financial assets are generally better off for now, having benefited from an immediate boost to your portfolios (including retirement accounts). Beyond this, however, the outlook is much more uncertain.

In announcing a further round of security purchases, the Fed is trying to engineer a delicate and complex policy sequence that runs something like this:

It buys securities in the marketplace in order to both lower mortgage rates and take an even bigger stock of "safe assets" out of the hands of investors. This should encourage us not only to buy houses, but also equities and other risky long-term financial assets.

Also, as asset prices go higher, we should all feel "wealthier" and have our "animal spirits" ignited. In turn, this would encourage consumption and investment spending ... and all this helps stimulate higher growth, more job creation, and less financial fragility.

Financial markets come early in this causation chain; and they are a critical element of the transmission mechanism that the Fed is pursuing.

No wonder the price of virtually every asset class rose following the policy announcement. In the U.S. stock market alone, the Fed helped engineer that day a $400 billion burst of "wealth" gains. The valuation surge is even larger when you include international equities, commodities, and corporate bonds.

This is not the first time that financial investors benefited from the Fed's actions. Since the 2008 global financial crisis, the central bank has aggressively used its balance sheet at least three times explicitly to boost asset prices. And, at least on paper, this round -- or "QE3" -- is even more powerful than the previous ones.

It is open ended. It is focused for now on just the mortgage market. And it is accompanied by a commitment by the Fed to maintain its foot on the policy accelerator well into the process of economic recovery.

But wait -- the Fed is not in the business of making investors happy. Its mandate is to maximize employment and maintain price stability for society as a whole. So, how likely is it that the financial sector's good fortune, prompted by the Fed, will end up providing the means to meet this dual objective?

This is where there are legitimate questions and concerns, and not only on account of the outlook for the next five years but also well beyond.

The Fed's hyper-activism, including venturing much deeper into experimental and unfamiliar territory, is neither cost free nor riskless. It critically depends on securing immediate broad-based benefits that overcome our economic malaise and change the momentum of the economy. Otherwise, it is very difficult to justify the real and present danger of collateral damage and unintended consequences.

If this big Fed bet does not work out, our generation will become even more divided and our children's generation will be left with the burden of cleaning up an even bigger economic, financial, political, and social mess.

So, how should you think of this delicate balance of potential outcomes?

First and foremost, recognize that as hard as it tries and as well intentioned as it is -- and I have no doubt whatsoever about both -- the Fed does not have the complete tool set to deal with our country's three basic problems: too little growth, too much debt in the wrong places, and too polarized a political system.

The answers to these challenges lie elsewhere in Washington, DC. If the Fed remains the only responsive policymaking entity -- as has been the case for way too long already -- it is only a matter of time before the costs of its activism overwhelm the benefits.

Second, internalize the likelihood that consumers and companies will face higher commodity prices than would have been the case otherwise. At the same time, as the Fed suppresses further interest rates, retirees will have even less real income on which to live.

Third, do not be surprised if the functioning of the economy and financial markets get more distorted, and if income and wealth inequality worsen further. Asset prices will likely flirt with, or be taken into bubbly territory (if they are not there already) and the average American will be limited to a narrower set of financial services.

Finally, other countries will not stand idle. They will act to counter the negative spillover effects from the unusual Fed activism. And it won't help that global policy coordination is virtually non-existent.

Whichever way you look at it, the Fed is engaged in a consequential and unprecedented high-stakes experiment. And it is not the only central bank in the world in this situation. The Bank of England, Bank of Japan and European Central Bank are also there.

If these central banks succeed, and we should certainly wish them well, they would enable the continued healing of economies that, for many years, got hooked on too much leverage, excessive indebtedness and unrealistic credit entitlement. They would provide a bridge for other, lagging policymaking entities to get their act together. And they would facilitate structural shifts critical to generating jobs, lowering inequality and countering the disturbing rise in poverty.

If, however, this historic policy bet on the part of central banks fails, current and future generations will be worse off. Moreover, the institutions themselves, which are critical to the well-functioning of any market system would damage their credibility and undermine political independence for a very long time. Have no doubts, we all have a huge stake in the success of the central banks' historic policy bet. We can improve the odds by pressing our elected political representatives to overcome their differences and encourage a broader set of policymaking entities to get their eyes back on the ball.

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