Quantitative Easing’s Lesser Known Side Effect

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This past weekend, I was at a barbecue at a friend’s house. While we did talk about such usual topics as the upcoming NFL season as well as the ongoing soap opera that is Alex Rodriguez, one of the questions I was asked was about the Federal Reserve. 

More to the point, my friend wanted to know why is there so much negativity surrounding the Federal Reserve and its quantitative easing program if it has helped the U.S. economy begin to emerge from the recession. 

That’s a great question, as the topic of the Federal Reserve is greatly debated and frankly can become quite heated. 

To begin with, as I’ve stated many times, during times of a financial emergency such as liquidity constraints, the Federal Reserve can indeed help stabilize the financial system through quantitative easing. Liquidity constraint simply means that normal business transactions are not being conducted because there are roadblocks along the way. 

The goal of any financial system is to produce the least amount of friction or constraints in conducting regular business. If you want to buy a loaf of bread or a car, this act should be easy. The process of transferring your wages into a product should be simple and seamless. If the company providing you a car loan can’t obtain funding for whatever reason, this impairs the financial system and slows down the economy. 

These are emergency situations only, and an aggressive quantitative easing policy, such as the $85.0-billion-per-month asset-purchase program that the Federal Reserve is conducting, should not be in place forever. 

While the U.S. economy is still growing at a slow rate, it is far beyond a crisis state of emergency. We are still creating jobs, not shedding them. Yes, it is true that the jobs are of poor quality, but simply pumping additional quantitative easing to fix a structural problem won’t help. 

What are the dangers? 

My biggest worry is that the current quantitative easing policy by the Federal Reserve is causing other assets to be mispriced, and bubbles are being formed. For example, with interest rates artificially low, investors are taking greater risks in trying to obtain yield. 

The problem is that these are not small, insignificant sums, but rather billions of dollars. Because I do believe that the Federal Reserve will begin to reduce its quantitative easing program, this will mean that the price of these assets will decline significantly. 

While you might personally not be buying junk bonds, but perhaps you have a pension plan, or a mutual fund that is involved in these markets. Indirectly, you might be negatively impacted, as investors have piled into riskier assets. 

Investments in some of the riskiest assets are soaring this year. Sales of junk bonds are up 24% during the first six months of this year versus last year, for a total of $235 billion. (Source: “Bond Hubris Overwhelms Fed in Riskiest Credit-Market Sectors,” Bloomberg, August 12, 2013, accessed August 12, 2013.) 

The Federal Reserve, by continuing its aggressive quantitative easing program, is creating a side effect in which investors are taking on far too much risk. I believe there could be significant negative costs once the quantitative easing program really begins to be reduced. Make sure that your investments are in assets that can withstand a shift in Federal Reserve policy. Avoid risky investments simply because they have a high yield.

by Sasha Cekerevac, BA 

This article was originally published at Investment Contrarians

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