Fed Selling volatility... what could go wrong?

Via Credit Suisse and soberlook.com

Credit Suisse has made an important point with respect to the Fed’s purchases of MBS. As we know, a mortgage borrower is long an option to prepay. That means a mortgage lender is short this same prepayment option. Therefore a buyer of MBS is an options seller and the Fed is in effect selling vol into the market.

CS: – It is important, in our view, that the Fed continue to sell volatility – explicitly or implicitly – into the markets. This is at the heart of its quest to reduce term premiums and hence term interest rates. Buying mortgages results in a direct sale of volatility (prepayment risk) to the public. Extending the rate guidance to “mid 2015” represents an implicit sale of volatility – the Fed is giving up the option to hike (arguments about the Fed’s ability to renege notwithstanding).

Of course this is quite similar to the ECB’s implicit put option on periphery debt (discussed here). As we’ve learned the hard way from the so-called “Greenspan’s put”, artificially suppressing volatility creates a “moral hazard” by forcing markets (including individuals and businesses) to misprice (and learn to ignore) risk.

My question- what if the Fed is forced into reducing the size of its balance sheet? For instance, when inflation expectations become unhinged. Inflation expectations embedded in the spread between Treasury and TIPS.