The Unintended Consequences Of Central Bank Policies

Includes: EFA, HYG, JNK, LQD, SPY
by: The Financial Lexicon

I recently stumbled upon an August 2012 working paper written by William R. White and released by the Federal Reserve Bank of Dallas. It is called "Ultra Easy Monetary Policy and the Law of Unintended Consequences." Given the Fed's enthusiasm for money printing, the title of this working paper caught me a bit by surprise, and I eagerly began to work my way through the first several pages. As I did so, the cognitive dissonance began to build. Did the Federal Reserve really allow such a stern critique of its favorite pastime, ultra easy monetary policy, to be published for all to read? Indeed, it did.

There is so much food for thought offered by White in his working paper that I could write several articles discussing the various points he raised. At this time, I would like to share two of his points, one from a subsection called, "Would private sector demand respond to easier monetary conditions?" and one from the conclusion of the paper.

On page 12, White discusses the "assumed positive relationship between the interest rate and the desired rate of saving." He mentions the conventional wisdom that lower rates will stimulate consumption, and then points out the difficulties with this notion by bringing up savers who have predetermined goals for the amount of savings they want to accumulate over time. For example, if you have calculated an amount of savings you wish to accumulate by a certain age, and you've assumed certain interest rates in the calculations, should interest rates plunge below your assumptions, you may decide that saving more is the appropriate course of action. If your income doesn't grow at a fast enough clip to offset the rising savings that are offsetting the lower interest rates, your disposable income will shrink. This increases the likelihood that you will cut your consumption rather than increase it.

In his paper, White states that, "if in fact the accumulation rate becomes so low that it threatens the minimum accumulation goal, the only recourse (other than postponing retirement) will be to save more in the first place." While I agree with White that lower interest rates could cause people to feel the need to save more (in fact, I know people for whom this is the case), I disagree that the "only recourse" other than postponing retirement will be to save more. There are other courses of action. These courses of action may not be desirable for all investors, but they do exist as options.

Some investors have moved money into equities in reaction to lower interest rates (I also know people who have done this). I've heard plenty of people argue that with funds tracking the S&P 500, such as SPY, yielding more than many higher rated short- to intermediate-term bonds, it makes sense to forego the negative real rates offered by such bonds and instead opt for the higher yield and capital appreciation potential of the stock market. In fact, investors willing to have an equity allocation tilted towards Europe can find yields of over 4% on broad market indices. One such example is the MSCI EAFE Index. The iShares exchange-traded fund tracking that index, ticker EFA, currently sports a 30-day SEC yield of 4.48%.

There also exists the option of extending duration in a fixed income portfolio rather than saving more. If you are willing to opt for long-term bonds, there are still investment grade corporate bonds (NYSEARCA:LQD) with decent yields available. I offer a few examples of such bonds in my recent article, "Earn More Than 6% With These 4 Bonds." There are also many other examples that can be found. And, should corporate bond spreads widen on worries of an economic slowdown, the list of higher yielding, long-term investment grade bonds will only grow.

A third option to saving more is to move down the fixed income credit quality scale and invest in high-yield bonds. Despite historically low yields in the junk bond market, if you are a person in need of fixed income and looking for an alternative to saving more of your disposable income, the allure of higher yields from speculative grade corporate bonds might be too much to pass up. If the risk of purchasing individual junk bonds is not to your liking, there are high-yield bond ETFs available that provide broad diversification and better liquidity than many individual bonds will offer. Two well-known examples are the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA:HYG) and the State Street Global Advisors SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK).

The second point made in White's paper that I'd like to share at this time comes from the conclusion. In it, he states:

"Of course the current crisis is not yet over, and the principal lesson to be drawn from this paper concerns governments rather more than central banks. What central banks have done is to buy time to allow governments to follow the policies that are more likely to lead to a resumption of 'strong, sustainable and balanced' global growth. If governments do not use this time wisely, then the ongoing economic and financial crisis can only worsen as the unintended consequences of current monetary policies increasingly materialize."

It's important to note the point White made about central bank actions buying time. The Fed and other central banks are not solving any of the world's structural problems by printing money. They are simply buying time. Unfortunately, if no solutions to the world's structural problems come about over the coming few years (whether they come from governments or the private sector), then the focus of central banks on short-term gains will likely create plenty of long-term pain in the form of many unintended consequences.

Disclosure: I am long HYG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.