U.S. savings bonds  © Corbis,  SuperStock

Larry Summers' letter withdrawing his name from consideration to head the Federal Reserve when current Chairman Ben Bernanke departs, presumably in January, is a reminder that even carefully watched, exhaustively reported and endlessly handicapped events can produce big surprises.

Until his withdrawal, Summers was considered the front-runner for the job. Now, who knows?

Current Vice Chariwoman Janet Yellen? Donald Kohn, the No. 2 at the Fed until 2010? A dark horse candidate such as Roger Ferguson, Stanley Fischer or Jeremy Stein? Could Tim Geithner, former Treasury secretary, be in the running despite his frequently expressed disinterest in the job?

Something that seemed settled is wide open again. And the effects on the financial markets are certain to be far-reaching.

Can I envision anything nearly as surprising for Wednesday's decision by the Federal Reserve's Open Market Committee on beginning versus not beginning to slow the pace at which the Fed is buying Treasurys and mortgage-backed securities? After all, the markets have had months to masticate any tapering in Fed purchases. You'd think the decision would be priced into financial assets by now.

I don't see much chance of a direct surprise. I think the big, liquid global markets -- such as those for Treasurys and currencies, including the dollar, yen and euro -- have discounted a modest Fed taper sometime before the end of this year. In a recent Bloomberg poll, 57% of investors say they don't expect a sudden change in the markets if the Fed does decide to start a taper on Wednesday. Their reason? They say they already anticipate a Fed taper.

I doubt that a Fed decision to taper this week or wait until October is going to produce more than a blip in the markets I've noted above, or in the big, liquid developed-economy stock markets.

But that doesn't mean I'm ruling out all chances of surprise.

I think we could get a surprise in less-liquid markets, which is where worry is more intense right now. That wouldn't require a change in the markets, just a continuation of the recent direction.

And that reaction could circle back to the globe's biggest asset markets. I doubt that's likely or that any move in developed markets would be big or long-lasting. But that's definitely where I'd be looking for any surprises in the second half of this week.

image: Jim Jubak

Jim Jubak

Let me take you on a brief tour of potential surprises.

The Fed is currently buying $85 billion in Treasurys and mortgage-backed assets each month to keep medium-term interest rates low. (The Fed controls short-term interest rates directly and has said that it will keep short-term interest rates at their current "extraordinarily" low level of 0% to 0.25% until 2015. The Fed has been trying to lower medium-term rates in the vicinity of seven-year maturities.)

The consensus is that the Fed, whenever it begins to taper, will do so very modestly, cutting back purchases from $85 billion a month to $75 billion or so. The first surprise, then, would be if the size of the Fed taper significantly exceeded $10 billion. A drop to, say, $70 billion, would be aggressive, but probably not enough to rattle the consensus.

A drop to a level lower than that would surprise and would undoubtedly lead to a selloff in both the bond and stock markets, though. I think the likelihood of a drop on that action is abundantly clear to the Federal Reserve.

And that's why this surprise is so unlikely. The U.S. central bank wants markets to get used to the idea of a gradual withdrawal of stimulus. That's what's been happening for the past three or four months as bond prices have fallen and yields have climbed. On Sept. 13, the yield on the 10-year Treasury closed at 2.88%. That's up from 1.87% a year ago. In that period, though, U.S. stocks have continued to climb.

The Fed wouldn't mind an increase in 10-year yields to slightly higher than 3% or a mild correction in U.S. stocks on the order of the 4% to 5% pullback in August. But the Fed doesn't want to whack the markets hard and risk endangering the U.S. economic recovery.

The Fed will begin a taper in 2013 because it has signaled to markets to expect the move, and anything else would damage the bank's credibility. But the bank doesn't want to move so fast and hard that it risks the modest economic recovery it has helped engineer.

Much more likely, but still not extremely likely, is a surprise in the mix of what the Fed buys. In the current program, the Fed buys $45 billion a month in Treasurys and $40 billion a month in mortgage-backed assets. To the degree that there is a consensus on how the Fed might balance a taper, it points to leaving purchases of mortgage-backed assets alone and reducing purchases of Treasurys.

That consensus rests on a couple of points. One is the belief that the Fed sees the housing sector as a key to keeping the economy in recovery mode and doesn't want to see mortgage rates rise. And second is the belief that the Fed is uncomfortable with its current holdings of Treasurys -- Ben Bernanke and Co. have virtually become the market for these medium-term maturities -- and would prefer to increase the market supply of these maturities.

This consensus will probably turn out to be correct, but greater-than-expected reductions in the Fed's purchases of mortgage-backed securities -- whatever "greater than expected" might turn out to be -- could temporarily spook mortgage real estate investment trusts and housing stocks. I doubt that the Fed will continue to reduce purchases of mortgage-backed securities in future tapering, so I'd see any panic on a possible Wednesday surprise in this sector as an opportunity for a short-term trade.

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Emerging markets seem most likely to turn a Fed taper into a surprisingly big deal. That's because emerging markets are already worried about cash outflows and weakening currencies versus the U.S. dollar. And because any suggestion that the Fed might be on the road to eventually ending its bond purchases will set some investors and traders in these markets wondering when the central bank might begin to raise short-term interest rates.

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