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Federal Reserve's 'Sterilized' QE3 May Get Messy

The Fed's plans aren't without risks.

First, under the proposal it would mean the Federal Reserve would trade directly with the money market industry. In previous attempts -- QE1, QE2 and Operation Twist -- the Fed only traded with "primary dealers." Those included some of the largest U.S. and international commercial banks, including Citigroup (C - Get Report), JPMorgan Chase (JPM - Get Report) and Bank of America (BAC - Get Report).

That means banks would no longer be direct beneficiaries of the Fed's liquidity largess which, according to Krishnamurthy, while risky is not necessarily a bad thing.

"The Fed would like to test bypassing commercial banks and go straight to the money funds. The Fed does so much with the banks that some diversification is really critical," Krishnamurthy said.

Also, by convincing money funds to buy up longer dated bonds it could push them out of the commercial paper market, a critical source of funding for companies as large as General Electric (GE - Get Report) to middle market manufacturers.

"If I am a money market fund with bunch of cash, I can either go into commercial paper or I can get the same yield with Fed as the counterparty and have Treasuries as collateral on a repo," Krishnamurthy said. "It doesn't get much better than that, and it could easily crowd out commercial paper."

Krishnamurthy ends up being in favor of the new Fed program, even if the stated purpose is about controlling stock market perceptions rather than addressing underlying economic growth.

"I'm on the Fed's side on this. Putting more reserves into the system this way is not inflationary," he said. "But in the end, it will depend how much of an appetite there is for this."

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