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3 headwinds facing the Fed

September 18, 2013: 10:19 AM ET

The economy is recovering but still very fragile as the Federal Reserve prepares to start tapering.

Ben Bernanke on Capitol HIll

Ben Bernanke on Capitol HIll

FORTUNE – It's a big day on Wall Street. As policymakers at the U.S. Federal Reserve wrap up with two-day meeting Wednesday, they'll decide whether the economy is solid enough to start winding down its stimulus program, called quantitative easing. The central bank's $85 billion-a-month bond-buying program has helped drive down long-term interest rates to historical lows, spurring everything from business investments to home sales and refinancing.

But as Chairman Ben Bernanke and the Federal Open Market Committee weigh the risks and gains of quantitative easing, their job gets more complicated when we look at a few economic headwinds that have emerged. Here's a look at three big ones.

Interest rates

The Fed has partial control over interest rates. Since the central bank signaled in May that it could scale down its bond-buying program, interest rates have risen higher; the 10-year Treasury yield is around 3%, up from less than 2% four months ago.

That's not necessarily a bad thing – so far, auto sales have soared and the housing market, although poised to slow down a bit, continues to recover. Because the economic recovery is still fragile, however, it could squeeze borrowers if costs go up too quickly. And that's something the Fed may caution against.

Already, the cost of a 30-year-fixed home loan rose to an average of 4.57% last week from 3.35% in May. While that's still historically low, the spike has nonetheless dampened the boom in refinancing – a development that's prompted job cuts at Bank of America (BAC) and others like JPMorgan (JPM) to lose money. Higher mortgages rates may not stall the housing recovery, but that could also depend how quickly rates rise and how quickly, if at all, borrowers might be able to adapt.

MORE: JPMorgan's London Whale fine is excessive and political

Debt ceiling debate

Something else the Fed will probably factor: Washington lawmakers face another debt ceiling deadline Sept. 30, which could potentially lead to more cuts in government spending.

Already, keeping cuts from sequestration in place through 2014 would cost the economy up to 1.6 million jobs, according to a Congressional Budget Office report in July. The latest debt ceiling deadline may not be as drama-filled as the previous two, but that will depend whether the Obama administration gets its way.

Republicans say they won't raise the debt ceiling unless it's paired with budget cuts and reforms, but the president has said it won't offer any.

A government shutdown would be awful for the economy, but a compromise that includes further budget cuts would also further dampen the recovery.

MORE: Sorry, Wall Street. Janet Yellen is no dove

Emerging market slowdown

There's also Brazil, China and other emerging markets to consider.  They helped lift the global economy out of the depths of the financial crisis, but after a decade of surging growth, these economies have slowed sharply. It's likely the trend will continue in the coming months, potentially sending ripple effects in the U.S. and the rest of the world.

For 2013, China is holding its breath to hit its official target of 7.5% growth; a marked drop from double-digit growth in previous years. Growth in India, Brazil and Russia is expected to barely be half of what it was at the height of the boom. Altogether, emerging markets may barely match last year's 5% growth, which sounds decent compared with the U.S. but it's the slowest in a decade.

Already, rising interest rates in the U.S., which could dramatically slow down sales in emerging markets, have put pressure on currencies and stocks from India to Turkey and Brazil. And banks with sizable investments in emerging markets, such as Citigroup (C), may feel it, as Fortune's Stephen Gandel points out.

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About This Author
Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

Email | @ninhaitseng | RSS

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