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The Fed Will Allow Business Cycle To Play Out Longer This Time!

Economics / US Economy Aug 27, 2011 - 02:39 AM GMT

By: Sy_Harding

Economics

The Federal Reserve played its part well, along with the Treasury Department, the White House, and Congress, in helping prevent the financial meltdown of 2008-2009 from turning the ‘Great Recession’ of 2007-2009 into the next Great Depression.

But its solo intervention with its QE2 quantitative easing program last year to boost the again faltering economy seems to have only delayed the business cycle.


Just over a year ago, unemployment was above 9%, home sales were declining, consumer and business confidence were deteriorating again, and the stock market had rolled over into a correction and seemed to be predicting the economy was sliding into another recession. And sure enough, in July of last year it was reported that the economy had unexpectedly slowed to growth of just 1.7% in the 2nd quarter of the year.

The Fed rushed in with its QE2 program of buying massive amounts of U.S. Treasury bonds on a monthly basis to give the economy a boost, admitting it was an experiment that had never been tried before.

The stock market surged up in response, the S&P 500 gaining a huge 34% from its low in July of last year to its peak in April of this year. Yet so-called ‘smart money’, including corporate insiders and institutional investors, seemed not to believe the QE2 program would work. The rally was on strangely low volume, few participants, and with corporate insiders selling into the strength all the way up.

The score card is now in on the Fed’s QE2 experiment.

Here we are a year later, and the economy is in worse shape than last summer. Unemployment remains above 9%. Home sales are on track to be worse than last year. Consumer and business confidence is at new multiyear lows. Government debt and deficits are a $trillion or so higher. And whereas last year economic growth was 3.7% in the first quarter and 1.7% in the second quarter, this year GDP growth was only 0.4% in the first quarter and 1.0% in the second quarter. This year the stock market again topped out in April and has given back most of the gains it experienced under the influence of QE2, potentially in anticipation that the economy is again sliding into recession.

This time, even though the economic slowdown in the first half was much worse than when it intervened last year, and monthly economic reports so far for July and August show the slowdown worsening so far in the 2nd half, the Fed has decided to let the business cycle run its course, at least for a while longer.

In his much anticipated policy speech on Friday, Fed Chairman Bernanke said the Fed will do nothing for now, but will take another look at conditions at its FOMC meeting on September 22. He also cautioned that the Fed’s powers are somewhat limited, apparently learning from last year’s mistake with QE2.

The business cycle is a dangerous thing to monkey with. It’s been in place since the founding of the country, and before that in other free-market systems.

Over the last 110 years there have been 25 bear markets, or one on average of every four years or so. The two times when they did not take place approximately on that schedule were in the 1920’s and 1990’s, when both times the economy and stock market continued for ten years without corrections of the excesses. The results were devastating, the 1929 crash and Great Depression, and the severe 2000-2002 bear market (which was then followed by the so-called ‘lost decade’ for the market, which remains well below its 2000 peak even 11 years later).

With the last bear market having begun in 2007, just about four years ago, the market may be trying to get back to its historical schedule of a smaller bear market on average of every four years instead of government induced longer bull markets and then more severe periods that follow.

Meanwhile, the Fed’s decision to let the business cycle play out at least for awhile longer this time does fit in with my prediction at my May 8 sell signal, that given the failure of QE2, the Fed will be less willing to step in this time, that the market is likely to experience a more significant correction in its unfavorable seasonal period this year, with the Fed not stepping in until the fall, to provide a boost just in time for the market’s next favorable seasonal period of November to May.

But the market does not move in a straight line in either direction, and after its severe plunge of the previous four weeks and the resulting short-term oversold condition, a short-term oversold rally has been underway this week in spite of the worsening economic reports.

Sy Harding is president of Asset Management Research Corp, publishers of the financial website www.StreetSmartReport.com, and the free daily market blog, www.SyHardingblog.com.

© 2011 Copyright Sy Harding- All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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