Fed's QE3 - how does it work and what are the risks?

A staff counts U.S. dollar banknotes at the Vietcombank's headquarters in Hanoi April 6, 2012.

CHICAGO (Reuters) - The U.S. central bank on Thursday said it will launch a fresh round of bond-buying to stimulate the economy, purchasing $40 billion of mortgage debt each month until the outlook for jobs improves substantially.

But just what does this so-called quantitative easing entail, and how does it work? Here are five questions and answers about it:

WHAT IS QUANTITATIVE EASING?

A central bank buys large amounts of assets -- in this case, bonds backed by housing mortgages -- in an effort to bring down interest rates and boost the economy. The Federal Reserve has tried quantitative easing twice before, thus earning this round the designation QE3.

HOW DOES IT WORK?

To buy bonds, the Fed essentially creates money from nothing, paying for its purchases by crediting the accounts of banks from which it buys the bonds. That's a clue as to how it works -- as money piles up in their Fed accounts, earning the paltry quarter-of-a-percentage point in interest that the Fed pays, banks may be keener to lend to companies and people. If companies use that money to buy equipment, and households use it to buy homes and cars, the economy gets a jump.

Fed bond-buying also helps the economy by pushing down borrowing costs. Massive buying of any asset tends to push up the prices, and because of the way the bond market works, rising prices forces yields down. Because the Fed is buying mortgage-backed bonds, the purchases act to directly lower the cost of borrowing to buy a home. In addition, some investors, put off by the rising price of the bonds that the Fed is buying, turn to other assets, like corporate bonds - which, in turn, pushes up corporate bond prices and lowers those yields, making it cheaper for companies to borrow - and spend.

WHY IS THE FED DOING IT?

By lowering borrowing costs and spurring banks to lend more, the Fed hopes to induce more spending and eventually set the stage for more hiring. This time around, the Fed tied its bond-purchase program explicitly to jobs, saying it will keep buying bonds until it sees a substantial improvement in the labor market.

HOW WELL HAS IT WORKED IN THE PAST?

Most studies show that quantitative easing does reduce borrowing costs, as measured by the yield on 10-year Treasuries. Studies are less clear on how much those lower borrowing costs translate into real economic improvement, such as the creation of more jobs. One model developed by Federal Reserve Bank of San Francisco chief John Williams last year suggested the Fed's second round of bond-buying -- $600 billion worth -- generated 700,000 additional jobs.

WHAT ARE THE RISKS?

Buying bonds expands the Fed's balance sheet. While the central bank says it will be able to shrink its giant balance sheet -- $2.85 trillion before its latest round of buying bonds begins on Friday -- without sparking inflation, it has never done anything like it before. Critics also say bond-buying enables Congress and the president to avoid dealing with looming fiscal problems by giving them a handy buyer for the nation's ever-increasing debt. Politicians in other countries have complained that U.S. quantitative easing cheapens the dollar and hurts their exports, and floods their economies with capital that is hard to absorb. The unprecedented stimulus could also draw accusations that the Fed is overstepping, ultimately threatening the Fed's independence should lawmakers move to curb its powers in response.

(Reporting by Ann Saphir; Editing by Alden Bentley)