Are You Making the Wrong Type of Investment for the Future?
One area that worries me most about the current Federal Reserve monetary policy action is the unintended, long-term consequences of the current program. Unintended consequences are the side effects that can sometimes be more harmful in the long run than the short-term benefit of the initial program.
Keeping monetary policy extremely easy in such an unprecedented manner for so long can have serious long-term ramifications.
The most obvious side effect is that, with the greater availability of easy money, funds are flowing into assets, driving up prices. The question is: will investors who are spending money on assets fueled by cheap money end up suffering significant losses down the road?
I am glad to see that some members of the Federal Reserve are beginning to voice their concerns regarding monetary policy. Recently, the Kansas City Federal Reserve President, Esther George, stated, “We must not ignore the possibility that the low-interest rate policy may be creating incentives that lead to future financial imbalances.” (Source: Torres, C., “Fed Concerned About Overheated Markets Amid Record Bond Buys,” Bloomberg, January 17, 2013.)
One potential worry is that the low interest rate environment resulting from this monetary policy action is causing investors to search for yield in increasingly riskier assets.
One area that has seen a strong increase in demand is speculative-grade bonds, or junk bonds. According to Credit Suisse, an index of over 1,500 junk bonds is now yielding a record-low 5.9%. (Source: Ibid.)
The problem is that when the Federal Reserve begins to tighten monetary policy, many if not all of the investments made over the past couple of years might suffer significant losses.
Just as the economy begins its recovery, if there are massive losses in such a huge diversity of investments, such as junk bonds and farmland, this could be quite problematic.
As an example of the extremely high demand for any yield, U.S. Treasuries are trading at 54 times the value of income, yielding 1.8%, compared to the S&P 500 trading at approximately 14 times earnings.
This huge demand for yield may end up costing investors a massive amount of money. By going further out on the risk profile to more speculative investments, if prices collapse when the Federal Reserve starts tightening monetary policy, these bad assets could be on the books for years.
While I could understand the Federal Reserve enacting extreme monetary policy measures during an acute financial crisis, keeping this plan in place for an extended period of time can only cause large imbalances in the economy.
As investors become used to the Federal Reserve’s easy monetary policy stance, this belief will become entrenched in the economy. This type of dangerous thinking gives investors a false sense of confidence, allowing them to take riskier investments.
For example, ask a bunch of homeowners who aren’t knowledgeable about historical interest rates if they think the cost of financing will go up over the next decade. You’ll find that most people will be shocked if you say interest rates should be at least two percent to three percent higher as a minimum across the board.
This strong belief in easy monetary policy will cause investors to take unnecessary risks. The Federal Reserve may have helped in the short term following the financial crisis in 2008; but keeping this type of monetary policy plan in place for such an extended period of time will only make the consequences of removing this aggressive stance and replacing it with a more neutral policy that much more difficult and costly down the road.
Of course, if there were structural reforms that prevented the buildup in the first place, the Federal Reserve would not need to create this type of monetary policy program. This is a much larger problem to deal with.
Personally, I believe the system should be much more dynamic and robust; not susceptible to collapse through just a few large firms.
This type of structural reform is beyond the scope of the Federal Reserve and the mandate they have been given. Unfortunately, structural reform needs to begin with the politicians in Washington.