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What Fed’s Actions Could Mean for Investors

Investors mark your calendars: Federal Reserve officials are considering three unusual steps to spur economic growth as they prepare to meet Sept. 20 and 21, according to a report in today’s Wall Street Journal. But experts say these options may not have the positive impact officials are aiming for. Here’s a look at the alternative moves being mulled by the Fed, and what they may mean for your portfolio.

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The Fed swaps short-term bonds for longer-term bonds in its portfolio. Known to some market watchers as “Operation Twist,” this move would aim to push down long-term interest rates so they’re lower relative to short-term rates. The goal is to encourage people to borrow more, buy homes or refinance. But the lower rates could force investors to take on more risk in the search for yield, says James Dailey, portfolio manager of the Team Asset Strategy fund (TEAMX). It would also lower the yields on other bonds that are priced off of Treasurys, such as corporate bonds, meaning investors would get paid less for taking greater risk, he says. For corporate bond holders, “not only would you have the credit risk of a junk bond, you now have a low yielding piece of paper.”

The Fed cuts or eliminates the 0.25% interest rate it pays banks to keep cash on reserve with the central bank. The goal here is simple: to stop rewarding banks for holding cash instead of making loans. “In theory it would encourage banks to lend more,” says Joseph Tanious, market strategist for J.P. Morgan Asset Management. But the move could have unintended effect: A return to reckless lending by banks and a likely increase in defaults, says Dailey.

The Fed gives more details on its policy goals. Under this scenario, the Fed officials would not just say they plan to keep rates low for an extended period, they may add the unemployment rate or inflation rate it wants to see before it would raise rates again.  Experts say this kind of explicit language would carry little weight because it’s not clear how much power the Fed would have once we reached those targets. “The problem is that Bernanke and the Fed have done all they can do at this point,” says Tanious. There’s also the chance the economy doesn’t act the way the Fed expects it to, says Dailey, and the plans they have in place for certain situations never come to fruition.

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