Now that the Federal Reservehas launched its third, open-ended, quantitative easing (QE3),investors need to consider the risks. Certainly Fed Chairman BenBernanke has. He outlined them recently at the Kansas City Fed'sannual conclave in Jackson Hole, Wyo. There, in addition toproviding considerable perspective on the extraordinary steps theFed has taken since the 2008-2009 financial crisis, the chairmanreviewed four critical risks involved in non-traditional policytools and procedures. He probably could have added a fifth.

Bernanke's first concern has to do with liquidity. The massivesize of the Fed's quantitative easings, he said, leads him to worrythat the markets in which the Fed operates could take on anadministered character. That quality could drive out privatetrading and, with it, the price discovery and liquidity on whichmarkets rely. Bernanke went so far as to say that the lack of a“free-trading” aspect in Treasuries and agencies, to use his words,could erode the lead these markets have offered in pricing andyield, making overall financial markets less efficient as well asweakening the overall effect of future Fed policy moves.

A second concern involves confidence. The chairman worries thatthe expansion of the central bank's balance sheet will raise doubtsabout its ability to adjust monetary policy, in particular itsability to exit from its present, highly accommodative stance. Evenif that concern is unjustified, Bernanke emphasized, such a loss ofconfidence could drive up long-term inflation expectations andthwart the Fed's otherwise carefully developed plans to “normalizemonetary policy” at some future date. Sadly, he failed to reviewthose plans.

Stability was third on the chairman's risk list. He worries thatnon-traditional policies, by driving down long-term yields onTreasuries, agencies, and mortgages, will induce investors to makean “imprudent reach for yield” that could in time produce lossesand destabilize financial markets. Bernanke was quick to point outthat the Fed saw no evidence of such a move as yet and wouldactually welcome more risk-taking by investors, at least withinreasonable bounds. But he did recognize that the underlying riskexists.

The chairman's fourth and final concern dwelton the potential for losses in the Fed's now immense securityholdings. Since the Fed turns all its profits over to the U.S.Treasury, any such losses would effectively add to the government'sbudget deficit. Against this concern, Bernanke offered reassurancethat the Fed's purchases actually benefit taxpayers by reducing thefederal government's deficit and debt, presumably by holding downthe cost of debt servicing. But he acknowledged that containinggovernment debt is less important than the Fed's efforts tostimulate the economy and so the country's living standards.

These four concerns revolve around what Chairman Bernankereferred to as the Fed's “balance-sheet tools,” but the Fed's new“communications tools” raise a fifth and potentially serious risk.A great potential for heightened volatility lies in policy makers'new practice of expressing their longer-term expectations of whereinterest rates are headed. When the Fed makes an interest-rateforecast, it effectively invites all investors to positionthemselves in a consistent way. Though the Fed qualifies itsexpectations by explaining that they depend on unfolding economicand financial conditions, the fact is that the public pays scantattention to such qualifications and believes instead in the Fed'sspecial insight and its power to enforce its expectations. As longas matters go as the Fed expects, this near-uniform positioningpresents little risk. But if unforeseen events force the Fed todeviate from its stated plan, such common positioning will requirethe bulk of market participants to adjust, disrupting marketsgreatly and adding to volatility.

Of course, policy shifts have surprised markets and beendisruptive in the past. But because the Fed previously kept itsrate expectations to itself, market participants positionedthemselves across a spectrum of possibilities. Some looked for rateincreases, some decreases. Some looked for a move sooner, somelater. When the Fed adjusted policy, only some market participantsneeded to adjust. Now, with the Fed offering official expectations,it would take a bold investor indeed to position himself or herselfin any way other than what the Fed indicated. Any Fed deviationfrom its stated path would force a much greater proportion of themarket than in the past to make portfolio adjustments, bringing onmuch more disruption and volatility. Unless Chairman Bernanke andhis fellow monetary policy makers have acquired a God-like abilityto see the future, this new communications tool could ultimatelycause more harm than good.

Nothing in this discussion aims to criticize the Fed'sextraordinary efforts to deal with the financial crisis and itsaftermath. Even considering all the risks, it is hard to see whatchoice policy makers had in the extreme circumstances of 2008-2009and have had in the difficult years since. But given these risks,it is also apparent that the jury is still out on the ultimateefficacy of these policies. By making his concerns public, ChairmanBernanke has offered a measure of reassurance that the Fed is atleast aware of the potential side effects of its powerful policymedicine and stands ready to deal with them. Markets now must seeif the Fed can and will execute on these comforting implicitpromises.