The Unintended Consequences of Fed Policy

For the most part, I think it’s safe to say that Central Banks are designed to help the economy.  As I’ve described before in detail, at their most basic level Central Banks are just big clearinghouses.  For instance, in the case of the Fed it’s really just an entity that oversees the clearing of payments in the interbank market.  This is an economic positive in that it creates a place where banks can settle payments across the payment network without having to worry about the quality of another bank’s financial assets given that they all deal in a form of pseudo government backed interbank reserves.  Overseeing the smooth operations of this system is the primary purpose of a Central Bank and it is, in my opinion, an unquestionable positive in a system where most of the money is created by risk taking private profit seeking banks.

Of course, Central Banks have become much more than just big clearinghouses.  They’ve become central policy makers via things like interest rate changes and other forms of policy (like QE).  Central Banks implement policy by trying to help the economy (obviously), but their toolkit is an extremely imprecise and blunt set of instruments.  Because of this imprecision there are often unintended consequences that arise  from such a broad instrument.

Today’s earnings report on IBM shed light on a recent trend that I have often criticized – corporate America’s fictitious obsession with boosting EPS by buying back shares.  Since the Fed implemented ZIRP and QE we’ve seen a huge boom in firms borrowing to boost EPS via buybacks.  It’s so inexpensive for a high quality firm to borrow and buyback shares that they can easily boost EPS this quarter without actually having to do anything substantive to the business.  In the case of IBM their revenues have been marginally higher over the last 5 years, but their EPS has shot up 50%.  That is, to a large degree, the result of a 22% decline in the share count thanks to buybacks.  It’s not necessarily “fake”, but it’s nothing like investing in the firm in a way that will create future organic EPS growth.  So these buybacks help in the present, but potentially hurt in the long-term.

There are plenty of other examples of the unintended consequences and the moral hazard of Fed policies.   But the question we have to ask ourselves is whether all of this Central Bank tinkering with interest rates and QE does more good than bad.  I don’t know the answer to that, but I do know that Central Banks operate with a very imprecise toolkit and so relying on them to steer policy over the course of the business cycle seems like a rather naive way to approach the goals of full employment, price stability and growth.