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Federal Reserve Chairman Ben Bernanke gave the markets a positive jolt on Friday after commenting that the central bank "should not rule out further use" of its stimulus policies. But more "quantitative easing," or buying things like Treasury bonds that push down interest rates and hopefully spur investment elsewhere, could hurt our prosperity in the long term while making it tough for savers to earn a respectable return.
This approach is called zero interest-rate policy, or ZIRP, and here's why it should trouble you.
Extremely low interest rates
You've seen the low interest rates in your savings accounts, where it's tough to find returns higher than 1% per year. That's happening because the Fed has lowered interest rates to nearly zero and pushed the yield of Treasury bonds to historic lows:
Since the central bank rate neared 0%, which theoretically stimulates the economy by offering cheaper capital to invest, the Dow Jones Industrials (INDEX: ^DJI ) gained 40% and the S&P 500 (INDEX: ^GSPC ) 45%.
However, while stocks can benefit from lower yields on Treasuries, those who have traditionally invested in Treasuries like pensions are finding it hard to earn returns. As Reuters reports, "in July the 100 largest company pension plans had their worst recorded month and now owe $533 billion more than they have assets to pay." Looking for what were traditionally Treasury-like yields of 4%, investors have had to take on more risk by investing into dividend-paying stocks, causing what some to say is a "dividend bubble."
Of course, the risk of investing in stocks and equities for dividend yields can bite back hard when both dividends are cut and stock prices decline. That's what happened with 14%-yielder mortgage REIT Chimera Investment (NYSE: CIM ) , which has cut its quarterly payout five times while the stock price has fallen by more than 30% since 2010. Even with safer dividend yields like Caterpillar's (NYSE: CAT ) 2.4%, investors have been burned by the share price's fall of more than 5% year to date.
Beyond current returns
There are many long-term worries over central banks' policies of keeping nearly zero interest rates, which the Fed plans on doing until 2014.
First, could the Fed raise rates even if it wanted to? Japan's central bank has held its rate below 1% since 1995 and has been unable to find a politically or economically receptive enough time to increase its rate. Of course, Japan has many different factors than the U.S., like a significantly aging population base. But given how markets react to more promised stimulus, Bernanke might find it hard to get the markets to accept increasing rates.
Another worry is the possibility that given another crisis, the Fed won't be able to further cut its rate and effectively stimulate the economy. This reality has already led to atypical solutions such as quantitative easing, but the Fed would have to come up with even more dramatic stimulus programs outside the norm -- perhaps purchasing the necessities for every household so that income can be spent on more luxuries?
Finally, there's the fear that any new monetary policy won't have any effect. With low interest rates, there's little difference between holding cash or investments, and cash holders expect interest rates to rise in the future. This situation is called a liquidity trap, because banks, consumers, and businesses would rather hold onto cash and keep their assets liquid instead of taking the risk of lending it out, buying a new boat, or building a new factory. So, no matter the amount of money pumped into the economy, it will build up savings accounts instead of creating new households, demand for boats, or new jobs.
Another energy drink for the economy
Whether Bernanke keeps trying to juice the economy or not, investors can help protect themselves from each Federal Reserve mumble by sticking with well-run companies that are reasonably priced. For example, Starbucks (Nasdaq: SBUX ) recently went on sale after a disappointing earnings statement, but it offers a savings-account-beating 1.3% dividend yield on top of a growing business both in America, with 7% same-store-sales growth, and in Asia, with more than 30% revenue growth.
For three other companies that are well run and offer dividend yields that beat the regular savings account, check out our free report: "The 3 Dow Stocks Dividend Investors Need."