The Federal Reserve Continues To Misinterpret The Economy -- Take Advantage Of It

by: John M. Mason

The officials at the Federal Reserve System are on a completely different page than I am when it comes to interpreting the condition of the economy. Mr. Bernanke and the Fed seem to believe that the problem is related to the need for more short-term stimulus to get the economy moving at a faster pace and to bring down unemployment. I believe that the economy is going through a transition period that is leading to major changes in how the economy functions.

My disagreements with the Fed are not new. I was just reviewing my blog posts from 2008 and 2009 to put them into book form and it is very clear to me that for most of the time that Mr. Bernanke has been the Chairman of the Board of Governors of the Federal Reserve System I have almost constantly disagreed with his understanding of the economy.

I wrote many posts criticizing the Fed's position during this time that the problems faced in the financial sector were "liquidity" problems and not "solvency" problems. In the early stages of a financial crisis, there is a liquidity problem. When the markets receive a financial shock and reverse themselves and have to re-adjust to new information, the holders of financial assets don't know what the price of their assets should be. Trading stops or substantially slows until traders start to understand where the prices of assets should be. The Fed should help traders by supplying liquidity so that a new price range for the market is found quickly.

However, a "liquidity" crisis only lasts for at most two months. During this two months it is vital that the Fed responds to the liquidity situation.

The situation then moves to another stage: the solvency crisis stage. When we move to this stage, asset prices stabilize, but at levels lower than many acquirers purchased them. Financial capital is less than it was before. In many cases, financial capital may be wiped out. At this time, the Fed must worry about keeping the banking system functioning so that the bad assets can be worked off or the insolvent institutions can be smoothly removed from the system. Here the Fed works together with the FDIC to resolve the "solvency" crisis.

For most of the Great Recession, Mr. Bernanke and the Fed have argued that they must replenish the liquidity of the financial system. For most of the Great Recession, Mr. Bernanke and the Fed have argued that the United States was in a "liquidity" crisis and acted accordingly. Now, Mr. Bernanke and the Federal Reserve are arguing for more and more short-run liquidity to get the economic system running at a faster pace so that unemployment can come down.

The economy is past the severe "solvency crisis" stage, but now the economy appears to me to be in need of restructuring. The current economic situation is not just about re-stimulating the economy to "goose-up" economic activity in the short-run. Maybe, the current economic situation is more about longer-run trends that cannot be reversed just by monetary or fiscal policy.

From 1950 to 1973, the U.S. economy at grew an annual rate of 3.9 percent per year. From 1973 to 2003, the U.S. economy grew at a 2.9 percent annual rate. Now, the U.S. is chugging along at a rate slightly in excess of 2.0 percent.

Furthermore, under-employment is somewhere around 20 percent and the labor force participation rate is slightly above 63 percent, the lowest rate since the 1960s. The capacity utilization rate in manufacturing is around 78 percent after about four years of economic recovery.

Maybe, just maybe, our current economic problems may be more structural than just short-term business cycle ones. But, this seems to be about the farthest thing from the minds of the officials in the Federal Reserve or in Washington, D. C. in general.

So, the push for more and more liquidity in the banking system goes on. We are promised that quantitative easing will continue for an indefinite amount of time. The most recent Federal Reserve statistics confirms the continued liquefying of the banking system.

Over the past 13 weeks, the Federal Reserve has added just under $300 billion to bank reserves. Note, that this amount is just about one-third what the whole Federal Reserve balance sheet was in August of 2008 .

The excess reserves in the banking system averaged $1.7 trillion for the two banking weeks ended March 20. This is almost twice what the whole Fed balance sheet was in August 2008! Again, to me, Mr. Bernanke and the Federal Reserve are misinterpreting the situation.

Mr. Bernanke seems to have one desire in running the monetary policy of the Federal Reserve System. His one desire seems to be to throw enough reserves into the banking system so that no future historian of the Great Recession and what followed can accuse him and his Fed of not erring on the side of providing enough liquidity to the banks. He seems to be obsessed with this and as long as the economy continues along its weak path, he will continue to follow his demon.

The problem with an economy that is re-structuring is that it takes time for the re-structuring to occur. In the 1930s and 1940s the U.S. economy was re-structuring. It was moving from a predominately agricultural economy to an industrial economy. No wonder the economy did not recover more quickly in the Great Depression and no wonder it took some massive changes in the industrial base during the Second World War to achieve the re-structuring needed so that the U.S. economy could begin expanding again in the 1950s. An annual growth rate of 3.9 percent from 1950 through 1973 is not too shabby. But, an economy always grows more rapidly in the earlier years of a new era. And, economic growth slows as the era progresses.

If we are going through such a transition period, and, given the current stance of the monetary authorities, I would argue that there are two ways people are going to make money investing going forward. First, the investor is going to have to determine what it is we are transitioning into. What industries are the emerging areas and which firms within those industries are going to be the leaders in the transition. This I will be writing about more and more going forward.

Second, however, an investor can look for those areas that are going to be most impacted by the Federal Reserve's largesse. These areas I have been writing about over the past six months or so. The game here is to see where Mr. Bernanke's bubbles are going to appear and jump on the bandwagon.

Just remember that you need to get onto the bubble as near the front as you can. Not only do returns go down as the bubble matures, but all bubbles do eventually collapse and you don't want to be around to experience that. If you miss one bubble, don't worry, there are others around.

Mr. Bernanke is very adamant about continuing to supply liquidity to the financial system. In such cases, it is not smart to fight the Fed. In such cases, it is much more profitable to "game the system." In fact, it seems as if you have Mr. Bernanke's approval to do so. A lot of people have benefited from doing so already!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.