Quantitative easing (QE) and negative interest rates are meant to stimulate economic growth; however, they also have the effect of incentivizing risk taking and creating the potential for asset bubbles. Stock buybacks, the overuse of cheap credit, and the existence of moral hazard are all linked to these unconventional forms of monetary policy

Stock Buybacks

A company can distribute profits to its shareholders in a number of ways, one of which is a stock buyback. In a buyback, a company will use retained earnings to purchase its own shares in the open market, both reducing the supply of stock available for investors and bidding up the price in the market.


Source: Fortune.com

When interest rates are very low, companies can borrow more cheaply by issuing corporate bonds at low yields. They can then use this money to purchase shares in a buyback. For example, Home Depot Inc. (HD) issued $2 billion in bonds partly to finance a share buyback scheme. The chart above shows the dollar amount of total buybacks for S&P 500 firms over the past two decades. There was a record amount of the activity leading up to the 2008 financial crisis when interest rates were low and then again following the market collapse as rates approached zero.

While buybacks are little different from paying dividends to shareholders to distribute cash, recently it appears as though that the growth in stock prices has exceeded profit growth. Companies are buying their outstanding shares at the expense of investing in capital projects. In fact, according to data provided by Bloomberg, the S&P 500 earnings growth in the period 2003-2007 was 12.9% while shares rose at an annualized rate of 10.8%. In contrast, the period from 2009-2015 saw corporate profits grow at only 6.9% while stock prices surged 10.9%. The incentive to borrow cheap to effect buybacks is an unintended consequence that artificially produces upward pressure on stock prices. (See also: Why Would a Comapny Buyback Its Own Shares?)

Asset Bubbles

It has been argued that one of the reasons for the housing bubble leading up to the 2008 financial crisis was consumers' access to cheap money for mortgages. A buyer of an asset with $2,500 a month of income to finance it can purchase a more expensive asset given a lower interest rate. The ability and incentive to buy more expensive goods on cheap credit drives up the price of the good and the value of the asset on paper, creating an asset bubble.

Since 2009, QE efforts have been correlated highly with the bull market in stocks as well as other asset classes. The chart below shows the price of the S&P 500 plotted against the size of the Fed's balance sheet, which gets larger as quantitative easing adds more securities to its books.


Moral Hazard & Risk Taking

The other behavioral consequence of QE and NIRP is that it encourages risk taking: If the central bank will make an expansionary policy move that will prop up asset prices, investors will buy those assets ahead of time in anticipation - driving prices up even further. This sort of risk-taking is a logical decision to make, especially if other market participants arrive at the same conclusion, even if it lacks fundamental support. (See also: Understanding Negative Interest Rates of Europe's Central Banks.)

The other issue with a perceived central bank backstop is the moral hazard, or taking excessive risk with the belief that there are no consequences for a loss. For example, a trader at a bank deemed too big to fail has every incentive to take on excessive risk: if he succeeds he will earn a handsome bonus; if he fails, he will lose his job but not be on the hook for a monetary loss. In fact, the central bank has signaled it will bail out affected institutions.

The Bottom Line

Unconventional monetary policy continues to dominate central bankers' decision making, as the Bank of Japan (BoJ) joins the European Central Bank (ECB), Sweden, Denmark and Switzerland in enacting a negative interest rate policy (NIRP). Along with quantitative easing, these policy tools are meant to stimulate economic activity, growth, and a moderate level of inflation. While these actions may be theoretically sound, there are possible unintended consequences of QE and low-interest rates as people are incentivized by these extraordinary monetary tools to make perverse economic decisions.

While central banks should do whatever they can in their power to promote growth and stability, they must also be aware of the potentially negative side-effects that their actions may cause.


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