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Why the Fed Can't Make Up Its Mind

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For more than a year now, a huge debate has brewed about where interest rates are headed next. Yet even after all that time, the answer to the long-awaited question of when those supposedly inevitable interest rate increases will finally start to happen hasn't appeared.

In fact, officials at the Federal Reserve, which is responsible for setting short-term interest rates, seem more divided than ever. Although their recent announcements have had unanimous votes, members of the Fed have made speeches and other announcements in between meetings that suggest some serious discord among the group. That leaves investors asking a vital question: How should you invest for the uncertainty resulting from the current standoff?

What's up at the Fed
From looking at Fed announcements, you wouldn't think there was any disagreement at all. Late last month, the Fed unanimously chose to continue its policy of keeping rates low, with plans to continue doing so for an extended period. Although the Fed is apparently taking the forward step of ending its current QE2 program on schedule at the end of June, it dismissed both recent strength in the economy and higher prices as not justifying any quicker action to raise interest rates.

But that hasn't stopped dissenters from making their voices heard. Thomas Hoenig, who is the president of the Federal Reserve Bank of Kansas City and a non-voting member of the Federal Open Market Committee, said over the weekend that past experience has shown the negative consequences of keeping interest rates too low for too long. Not only does the increasingly apparent influence of rising inflation worry Hoenig, but also the potential for disruptions in the behavior of investors that extended low rates have caused.

How savers are coping
That last point should ring true with plenty of conservative investors. Even just a few years ago, savers could count on earning 3% to 5% on ultra-safe short-term investments like bank money market accounts or Treasury bills. That allowed them to earn a reasonable income on their nest eggs without worrying about taking on market risk from stocks or interest rate risk from longer-term bonds.

Now, though, the near-zero income potential of short-term investments have forced those savers to resort to higher-risk investments. On the fixed-income side, savers have had to replace Treasuries with the higher-yielding corporate bonds that SPDR Barclays High Yield Bond (NYSE: JNK  ) and iShares iBoxx High Yield Corporate (NYSE: HYG  ) own. Junk bonds have gotten those investors back to the 5% and higher yields that they're used to, but at the cost of owning longer-maturity bonds that carry interest rate risk as well as assuming the default risk from issuers with lower credit quality. Similarly, some have turned to municipal bond investment iShares S&P National Muni Bond (NYSE: MUB  ) for better rates and tax-free treatment, but have taken on the considerable credit risk of ailing state and local governments.

Jumping into stocks
Even more alarming are those who have shifted their asset allocations too far toward stocks. It's true that even retirees and conservative investors can benefit from having some of their money invested in the stock market, and dividend yields are at extremely high levels. The diversified stock ETFs SPDR Dividend (NYSE: SDY  ) and iShares DJ Select Dividend both have yields of more than 3%.

But often, income-hungry investors gravitate to the highest-yielding stocks they can find. That can lead to disappointment when dividends get cut unexpectedly. That's happened to shareholders of Frontier Communications (NYSE: FTR  ) , World Wrestling Entertainment (NYSE: WWE  ) , and to a lesser extent Annaly Capital (NYSE: NLY  ) , all of which have seen or will shortly see smaller dividend payments. Frontier's and Annaly's cuts haven't translated to big losses for shareholders, but World Wrestling Entertainment has seen its stock fall sharply since the announcement.

Stay aware
The debate at the Federal Reserve is likely to continue for a while. Overall, the Fed's long-held policy of low interest rates may prove beneficial for the economy as a whole. But investors have to take care not to fall prey to the short-term disruptions that those low rates are causing. As painful as it is to keep money in low-yielding safe investments, a responsible asset allocation may require you to accept near-zero interest in exchange for the security you need. Trading up for more income could leave you vulnerable to rate hikes in the future -- whenever they eventually happen.

All the same, for the part of your money that should go into stocks, buying dividend-paying stocks can be a smart move. Read the Fool's special report to see 13 smart stocks that pay dividends. Get your free copy today by clicking here.

Fool contributor Dan Caplinger only vacillates about silly things. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy makes decisions easier.

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