BOHANON & STYRING: Fed may spur investors to take too much risk

Central banks have been following “unconventional” monetary policies in buying huge quantities of government and private securities via quantitative easing. From its birth in 1913, the U.S. Federal Reserve took 95 years to amass a balance sheet of $800 billion. In the next eight, the balance ballooned to over $4 trillion. Along for the ride are near-zero short-term interest rates. The German, Swedish and Japanese governments have actually borrowed at negative interest rates.

Either someone spiked the punch bowl at central bank governors meetings or the world has gone nuts. Talk is that this ultra-low interest rate environment is the “new normal.” What are the implications of ultra-low rates effectively forever? We can think of at least two.

First, note that these near-zero-or-below rates mainly play out for investments that offer safe returns—like insured bank accounts, bank CDs and short-term government bonds. From 1993 to 2000, the average rate of return on the one-year U.S. government bond was around 5 percent. A retired couple with a nest egg of $250,000 could supplement their Social Security income with an additional $1,042 a month from super-safe treasuries with little to no risk to the capital.

Compare this to the last eight years, when one-year U.S. government bonds have had an average rate of return just above 0.25 percent. The retirees with the $250,000 nest egg so invested have seen their income supplemented by about $52 a month. So, work hard, scrimp and save, look for a safe haven so as to pass something on to the kids, but forget about any current income. Thanks a lot, Fed.

Which leads to the second point: If there is little payoff to safety, investors will be induced into riskier investments in search of higher returns. Our retirees will be increasingly likely to switch their nest egg into an exotic investment strategy that promises a 10-percent-plus annual return. Our couple will enjoy a $2,000-a-month supplement to their income plus growth in the investment’s principal if everything works out as planned.

Great! But here is a rub: Things don’t always work out as planned. Think of all the folks who put everything in the stock market in 1929, or in Enron stock in 2000, or in mortgage-backed securities in 2007. This is a bad movie we have seen before. Is this what the Fed is setting up?•

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Bohanon is a professor of economics at Ball State University. Styring is an economist and independent researcher. Both also blog at INforefront.com. Send comments to ibjedit@ibj.com.