Fed’s low-interest-rate policy is a threat

Whether the Federal Reserve’s plan to keep interest rates near zero for a protracted period of time will encourage the business sector to expand is open to debate. But one thing is clear:

Keeping rates so low, for so long, will change the behavior of consumers, probably in harmful ways.

Persistently low rates, which discourage rather than encourage savings, could give rise to a new generation of spenders. Over the long term, artificially low rates also distort investors’ perception of risks, leading otherwise prudent investors to take risks that they wouldn’t in ordinary times.

Finally, rock-bottom rates could lead those who saved religiously over the years — resisting temptation to spend lavishly on vacations or on homes that would have stretched their budgets — to feel as if they are fools.

They are the middle-age and older investors who pulled in their belts so that they could live comfortably during retirement. Over time, many followed their financial advisers’ traditional advice and shifted savings from riskier investments into more stable certificates of deposit and Treasuries as they aged.

Now look at their rewards: One-year CDs that yielded a minuscule 0.34% for the one-week period ended last Thursday, and five-year yields at 1.16%.

Savers depositing $100,000 earned 0.37% on a one-year jumbo CD, on average, while five-year jumbo CDs returned 1.18%, according to Bankrate.com.

Meanwhile, the average money market account was yielding 0.13% for the seventh week in a row, Bankrate.com said.

And the yield on a 10-year Treasury stood at 1.87%.

Where is the incentive to save? There is none.

If the Fed policy continues and the stock market continues to languish, millions of Americans are likely to abandon efforts to sock away any money at all.

SAVINGS DECLINE

It isn’t a good sign that the personal savings rate slipped to 4.4% last year, from 5.3% in 2010, according to the Commerce Department. Although much of the drop in savings may be due to the fact that Americans are working harder to make ends meet in a world where the cost of living is rising at a rate higher than yields on savings, there are fears that it is a harbinger of things to come as artificially depressed interest rates continue to punish prudent savers.

And that isn’t all. The longer rates stay this low, the more they will distort the investment patterns of mom-and-pop investors.

Normally conservative investors soon may find themselves compelled to take on significantly greater risks to replace yield that they can’t get from CDs or money funds.

Retirees, suddenly fearful of outliving their savings, may succumb to the temptation to ramp up their stock allocation to a level inappropriate for their age.

So far, the Fed seems willing to let prudent savers bear the cost of reinvigorating the economy. Two weeks ago, the central bank indicated that it will maintain the target range for the federal funds rate at 0% to 0.25% until late 2014, extending the period from mid-2013.

To be sure, the Fed must walk a fine line between encouraging risk taking to stimulate growth and discouraging excessive risk taking to the point where it threatens the safety of the financial system.

Advisers also must walk a fine line. As trusted custodians of their clients’ hard-earned savings, it is up to them to seek out the best returns during this long period of artificially low rates, as well as avoid the excessive risks that can come with striving for higher yields.

PRACTICAL SOLUTIONS

In clients’ search for yield, advisers can help in less obvious ways.

For example, they can recommend that clients use a credit union rather than a bank. The majority of credit unions don’t charge monthly fees for checking accounts and often pay higher rates on savings accounts.

During times like these, advisers also should resist the temptation to reallocate clients’ bond portfolios into longer-duration issues. Although the yields on those issues are certainly higher, clients in long-term bonds will take a much bigger hit when rates begin to rise.

True, the yield on those issues will offset some of the damage inflicted by falling bond prices, but probably not enough to preserve clients’ savings.

Finally, it makes sense to focus clients’ stock portfolios on companies that pay dividends. High-quality stocks that come with a 3% to 5% dividend payout may help clients keep pace with inflation.

Rates eventually will rise. Until they do, however, it is up to advisers to keep encouraging younger clients to save aggressively for their retirement and discouraging retired clients from taking unsuitable risks.