Don't fear the current recession drumbeat, Revisited

Back in November, we wrote a post entitled "Don't fear the current recession drumbeat," in which we argued that the chorus of predictions that the consumer would drive the economy into a recession because he could no longer borrow as much against home equity was misguided.

Since then, we have seen oil rise to record highs, and the major stock market indexes experience a harsh bear market, dropping over 22% between the October 9th high (for the S&P 500) and Tuesday's closing price from this week (July 15th).

Given these results, were our denunciations of those arguing for a consumer-led recession misguided? Should we retract those statements and admit a major flaw to our reasoning?

Well, no. The economy has not, in fact, experienced a recession. Although growing more slowly, it is still expanding, and this week total industrial output in June was announced to have grown by 0.5%, against expectations of 0.1%. We would also add that if the Fed were to raise rates, and stem the dollar's decline, we would actually see a reacceleration of growth. Businesses put off decisions on longer term strategic investment if they suspect rates will go lower and/or the purchasing power of their dollar may be undermined by inflation.

Unfortunately, what has happened is that the Federal Reserve began drastically cutting interest rates last fall, as depicted in the revealing graph above, which comes from this insightful opinion piece in yesterday's Wall Street Journal.

That graph shows clearly that the doubling in the price of oil, from a little above $70 a barrel last fall to recent prices above $140, correspond exactly to the emergency loosening in monetary policy by the Fed. This is exactly what we have argued previously, for example in this post from June 4. Furthermore, although the Fed (in particular Chairman Ben Bernanke) has given lip service to the inflation/dollar-decline problem, mere lip service has only served to exacerbate the problem we describe.

In spite of what you hear from many commentators on the financial media shows, the supply and demand characteristics of oil did not change dramatically in the past few months: what changed was the Federal Reserve, which has been too loose for years but exacerbated the problem further starting in the fall with their attempt to steer the economy out of the financial mess created by the CDO boom that they helped to create.

This most recent Fed over-reaction is at the heart of the oil spike, as well as the inflation pressures we are now experiencing (the inflation pressures were started by their earlier too-loose position, and the recent loosening will cause that inflation to spike further in the months ahead). We have explained previously that the Fed's attempts to steer the economy, rather than provide a stable currency for businesses and citizens, are causing inflationary problems that impact everyone.

At this juncture, we continue to argue that ownership of good businesses should form the foundation of wealth planning. Charts contained in links at the end of this post demonstrate that even in an inflationary environment, stocks in companies that add value to the economy (and can therefore raise their prices to keep up with inflation) are the best store of value for longer periods. The lower prices resulting from a bear market provide opportunities to add to investments for those able to do so, as we have also stated previously.

We would also add that, on top of the main foundation of ownership in good businesses, if you own securities producing income streams (such as interest-bearing instruments), it is important to diversify those income streams. Don't get all your income from CDs issued by a single bank, in other words. On top of the main foundation of equity in good businesses, we advise ownership of a diversified income strategy for those whose situation calls for it, and even ownership in the stock of non-public start-up companies when appropriate.

In spite of appearances, the economy itself is not going off a cliff. It is important to have a clear understanding of the causes of the current environment, in order to make the correct decisions in the conditions we are currently experiencing.

for later blog posts dealing with this same subject, see also:

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