The Federal Reserve has cranked up the bubble-machine again, pumping up opportunities as well as risk.
In doing so it is on the wrong side of the economic cycle again, as it so often has been in the past, beginning to ease too late to prevent recessions, and then continuing to ease too long after recoveries are underway, creating bubbles.
For example, in 1998, although having already warned of the inflationary risk in the overheated economy and “irrational exuberance” in the stock market, the Greenspan Fed panicked when Asian markets began to collapse. It cut interest rates to hold the U.S. stock market up, producing another round of irrational exuberance, and boosting the stock market up into the 1999 bubble. The Fed did not reverse and begin tightening monetary policy until June, 1999, and by then it was too late. The bubble was formed and burst with dire consequences in early 2000.
Then, apparently not realising the stock market collapse was an advance warning of a coming recession, the Fed continued raising interest rates until May, 2000, and did not begin cutting interest rates to prevent a recession until January, 2001. By then, the 2001 recession was already upon us.
To help pull the economy out of the 2001 recession the Fed then cut rates a total of 13 times, not stopping until June, 2003, well after the economy was recovering and the 2002-2007 bull market was well underway.
And that failure to get ahead of the curve resulted in the real estate bubble. When it burst, the resulting recession of 2007-2009 was the worst since the Great Depression, and the 2007-2009 bear market was the worst since the 1930’s.
This time around it seems the Fed had it right last spring when it ended its first round of quantitative easing in March, earlier than scheduled. It said low interest rates would be needed “for an extended period”, but it was time to begin removing the other massive stimulus efforts of 2008 and 2009. The recession had ended in June last year and the economic recovery was underway.
It stuck with that outlook until August, projecting that economic growth would slow for a couple of quarters but not into recession, and then begin to grow again in the last half of the year and through next year.
But in August, when the stock market was down and economic reports from the summer months were worsening (as the Fed had supposedly expected) it panicked, reversed its bias and promised a second round of quantitative easing “if needed.”
When the economic numbers began improving three or four weeks ago, I was sure the Fed would decide the “if needed” conditions had not arrived yet (and might not), and would either postpone the decision on QE2, or announce a very watered-down token program. I wrote a column three weeks ago titled Is The Fed Sorry It Even Mentioned QE2?
But no, at its FOMC meeting this week the Fed remained in panic mode and announced an aggressive program in which it will pour roughly $100 billion a month of additional liquidity into the financial system until next June.
I believe part of the Fed’s problem is allowing itself to be influenced by the complaints from Main Street and Washington regarding the high level of unemployment, and that the economic recovery is not creating jobs fast enough. The Fed singled out the continuing high unemployment as a major reason more easing is needed.
But surely the Fed knows that employment is a lagging indicator, and using it as a leading indicator for its policies is almost sure to have it on the wrong side of the cycle. Employers don’t begin hiring more workers to any degree until the economy has already recovered significantly enough that they can no longer keep up with increasing business by giving current workers more hours, and hiring part-time help.
The Fed has apparently ignored recent jumps in the ISM Mfg Index, ISM Non-Mfg Index (service sector), retail sales, durable goods orders, and the like, which indicated even the point in the recovery may be near where the employment situation improves.
That seemed to also be indicated on Friday by the labour Department’s latest monthly employment report. It was that 151,000 new jobs were created in October, the highest number since May, more than double the forecasts of 70,000 that economists expected. And the previously reported numbers for August and September were revised to show 103,000 more jobs were created over those two months than previously reported.
The evidence that the Fed is again behind the curve could hardly be clearer.
So at this point, the additional liquidity the Fed has decided to pump into the financial system will surely go toward continuing the Fed’s history of creating bubbles.
Picking the location of those bubbles will probably be very profitable over the next year or two. The initial betting is that they’ll be in commodities and emerging markets, and that bond prices will tumble. Other possibilities will also emerge. It’s bubble-detecting time!
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