Does The Recent Jobs Report Indicate The Fed Is Behind The Curve; Again? (DIA, SPY, DDM, DXD, DOG, UPRO)

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February 5, 2012 12:48pm NYSE:DDM NYSE:DIA

Sy Harding: As I have often written over the last 25 years, the Federal Reserve has a lousy record of almost always being woefully behind the reality curve at important turning points in economic


Is it adding another layer to that statistic in its current position, stated just last week in its FOMC statement, that it thinks the outlook for the economy is so negative it intends to keep the Fed Funds Rate at near zero “at least through late 2014”, rather than its previous target of mid-2013?

In its statement it noted that the Fed’s statutory mandate is to “foster maximum employment and price stability” and that it expects economic growth over coming quarters will only be “modest” and “the unemployment rate remains elevated”.

So it says it will keep interest rates near zero for almost two more years, and stands ready to provide further stimulus if needed “to promote a stronger economic recovery.”

If we get much more evidence of the quickening pace of the economic recovery, by late 2014 Fed Chairman Bernanke may instead be ducking brickbats of criticism that once again the Fed waited too long to raise rates to cool things off.

I’ve written in the past about the Fed’s long time record of being too late in raising rates to cool off the economy, resulting in the economy overheating and the stock market rising into bubbles, and equally late in cutting rates to prevent slowing economies from entering recessions. It takes so long for changes in policies to work their way down into the economy that it would have to foresee the future well in advance, and act early, in order not to be too late. And it has rarely been good at that.

For instance, the 1999 stock market bubble was the result of Fed action in the fall of 1998, when Asian and Latin American economies looked to be in trouble at the same time the U.S. stock market (NYSEArca:DIA) was down 19% in a correction. Even though then Fed Chairman Greenspan had made it clear he wanted some of the air let out of the stock market, the Greenspan Fed quickly cut interest rates and pumped money into the monetary system. Greenspan explained that the Fed did not think the world economy could handle a stock market collapse in Asia and Latin America and in the U.S. at the same time. The rate cuts had the desired effect of stopping the U.S. stock market’s decline in its track. In fact the stock market took off like a rocket, hitting new record highs and records of overvaluation in 1999, which resulted in the 2000-2002 bear market (NYSEArca:DOG), the most severe since the 1929-32 crash.

The problem was that once the Asian worries were off its mind the Fed began raising interest rates again in 1999, but only slowly, 0.25% at a time, and did nothing about the excess liquidity it had pumped into the market in late 1998 in response to the Asian scare.

So a stock market bubble and resulting severe bear market. [Related: ProShares Ultra Dow30 (NYSEArca:DDM), ProShares UltraShort Dow30 (NYSEArca:DXD), ProShares Short Dow30 (NYSEArca:DOG)]

In 2004 and 2005, the Fed kept the easy money policies it used to pull the economy out of the 2001-2002 recession in place far too long, creating a bubble in the housing market.

Then in 2007, just months before the 2003-2007 bull market rolled over into another severe bear market, that of 2007-2009, the Fed was behind the curve in the other direction again. By then it had raised interest rates in a belated reaction to the formation of the housing bubble, and kept the rates too tight too long because it did not realize the serious consequences to the economy that would come from the bursting of the housing bubble in 2006. [Related: SPDR S&P 500 ETF (NYSEArca:SPY), ProShares UltraPro S&P 500 (NYSEArca:UPRO)]

As I was writing at the time, and recent minutes from the Fed’s discussions in 2007 confirm, the Fed (and Wall Street, and the White House) were convinced the problem would be confined to the real estate sector. And even when the sub-prime mortgage market subsequently collapsed, it was still sure the problem would go no further into the economy.

Even when the Dow plunged 1,140 points in reaction to the collapse of Bear Stearns hedge funds, indicating the mortgage mess had spilled over into the rest of the financial sector, the Fed made only a token cut in the discount rate that troubled banks pay to borrow money from the Fed.

Only when the home sales numbers plunged further, and Wall Street began saying the Fed would have to respond, did the Fed become concerned enough to begin cutting interest rates to try to prevent the economy from slowing too much.

But again it was way behind the curve, with too little too late, and wound up having to cut rates to the current near zero level all the way down through what turned out to be ‘The Great Recession of 2007-2009.

So it is a legitimate question to ask if the Fed is again behind the curve in stating its intention to hold rates near zero until “at least late 2014”, while standing ready to provide another round of quantitative easing if necessary, even as the economy is in the third year of recovery from the great recession, and albeit still anemic, is picking up momentum at an unexpected pace.

I expect the Fed will have to begin raising rates well before the end of 2014 if it is not to fall behind the curve again.

No, no, no, I’m certainly not saying the economy is overheated or the stock market is in a a bubble. Just that it’s likely to become so if the Fed were to keep interest rates near zero until late 2014. And that the Fed announcing its new intensions to do so last week, even as the economic recovery is in its 3rd year and showing signs of picking up to more normal momentum, is an indication the Fed will continue its record of being behind the curve at important turning points, with the same unfortunate consequences as in the past. But that’s a problem for down the road.

By the way if you’d like to read what I was saying in 2007, click here, What Did They Really Say- August 31, 2007. There are some interesting quotes from Ben Bernanke at the time.

Written By Sy Harding From Street Smart Report

Sy Harding is editor of the Street Smart Report, and the free market blog, The Street Smart Report Online includes research and analysis on the economy and markets, and provides charts and buy and sell signals on the major market indexes, sectors, bonds, gold, individual stocks and etf’s, including short-sales and ‘inverse’ etf’s. It provides two model portfolios as guides. One is based on our Seasonal Timing Strategy, one on our Market-Timing Strategy.

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