The Federal Open Market Committee (FOMC) released its latest statement on monetary policy on January 28, 2015.  Since the Fed ended its QE program in October, most of the focus has been on interest rates.

The statement said the following:

“Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.  However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated.  Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.”

All of this focus is on the federal funds rate (the overnight bank lending rate).  But despite these threats of higher rates from the Fed, long-term interest rates are falling.  Investors either don’t believe what the Fed is saying or they really don’t care.

I am expecting and preparing for a recession.  I don’t know when it will come, but the Austrian Business Cycle Theory tells us that it should come.  The Fed has had six years of high monetary inflation and there is little question that this has generated bubbles and misallocated resources.  The bigger question is when this will fall apart.

Perhaps an even bigger question is how the Fed will react when the bubbles start to deflate.  Will it watch it happen or will it start another round of QE?  While we can’t be sure, my bet would be on the latter.

Right now, I feel like Janet Yellen is a magician.  She is distracting everyone with one hand.  That is interest rates.  But nobody is paying attention to the other hand.  That hand is about to pull a rabbit out of the hat in the form of new money.

Again, the timing of this is impossible to predict, but we shouldn’t be surprised when it happens.

The European Central Bank (ECB) has announced its own version of quantitative easing (QE).  It will start buying 60 billion euros of assets each month, going well into 2016.  This will total at least 1.1 trillion euros, which is approximately 1.3 trillion dollars.

I see this as the ECB trying to imitate the Federal Reserve.  The Fed has quintupled the monetary base over the last 6 years, with its biggest round of monetary inflation coming to an end this past October.  Yet much of this money went into bank reserves and consumer price inflation has stayed relatively low.

It is almost as if the Fed has had a free lunch.  It has gotten away with its biggest round of monetary inflation ever with few consequences.  Meanwhile, the U.S. economy is looking better, especially when you compare it to Japan or Western Europe.

It might almost seem rational for the ECB to try to imitate the Fed.  Much of Western Europe is in recession or worse and the price inflation is low there as well.

Unfortunately for the Keynesian central bankers of Europe, things might not turn out the way they plan.  Mario Draghi, central banker and former Goldman Sachs guy (or do I repeat myself?), may not get off as easy as central bank officials in the U.S.

First, it is important to point out that things have not played out in the U.S. yet.  The economy is seemingly strong and much of it is because of the Fed’s inflation.  But asset bubbles take some time to pop.  The popping of the oil bubble may just be the beginning.  Perhaps stocks are not far behind.

The point is, central bank inflation misallocates resources and it slows down productive growth.  At some point, these misallocated resources get exposed and the realignment usually means a recession, unless it is not too severe and other areas with strong productivity are able to offset it.

The second problem for Europe and the ECB is that Europe is not the same as the United States.  There is simply not as much real wealth.  The U.S. is a very entrepreneurial society and there is a lot of wealth from 200 plus years of capital accumulation.  Western Europe has been more of a hardcore welfare state and is relatively poorer in general.

When there is less in the way of real wealth and real savings, then things can’t be covered up as long.  The people of Greece are finding this out the hard way right now.

When there is a large amount of government spending, coupled with central bank inflation, a wealthier society can withstand it better, at least for a period of time.  There is more real wealth to sustain things.

It is no different than a family.  If you have to take a pay cut and you are spending more than you are earning, you will be able to better withstand the situation if you have a lot of prior savings.  In terms of a country, I am not talking about government savings.  I am talking about real wealth that is owned by the individuals.

The ECB may find that its policies have almost no effect up front.  Meanwhile, they will be misallocating resources and hurting long-term wealth production.  It will wipe away what little savings are left there.  If much of Europe finds itself in recession, maybe the ECB will up the ante and create even more inflation.  But then it will just exacerbate the problem more and they may end up with a depressed economy and high price inflation at the same time.

Overall, it isn’t going to be pretty for Western Europe in the long run.  The ECB is making things worse.  It is wasting real capital and real wealth.  If I were living in Western Europe right now, I would want to be in Switzerland, away from the euro.

The big financial news this past week was the announcement by the Swiss National Bank (SNB) that it would drop its peg to the euro.  The SNB announced this peg in September 2011, where it would not let the franc rise against the euro.  The peg was set at 1.2 francs per euro.

In order to maintain this peg, it meant that as the European Central Bank depreciated the euro by creating money out of thin air, the SNB had to essentially do the same thing.  The SNB, over the last 3 years, has had to buy up euros, mostly with newly created francs.

While this temporarily helped exporters in Switzerland, it hurt all consumers in Switzerland by making things more expensive.

This past week was the final straw, as the SNB realized that it wasn’t up to the massive monetary inflation that would be necessary to keep up with euro, particularly with the anticipation that the European Central Bank is about to announce a massive monetary inflation scheme.

It is good news for most of the Swiss that the SNB has dropped this ridiculous peg.  The franc has been an historically strong currency, but its reputation was evaporating quickly before this past week.

The announcement will mean several companies and investors will be severely hurt or bankrupt, but that is because they were betting on the continued peg.  The “carry trade” – where investors would borrow francs at low rates and exchange them for other currencies that pay higher rates – was a popular thing, but it will now mean a lot of pain for those who tried it and now have to convert back to francs.

The SNB never should have attempted its policy, as it can now see.  But at least it is abandoning this bad policy, even though it will hurt some people in the short run.

PRPFX

My favorite mutual fund is PRPFX.  It somewhat mimics the permanent portfolio that was advocated by Harry Browne.  I recommend that investors put a minimum of half of their financial assets in a permanent portfolio setup.

I say that PRPFX “somewhat mimics” the permanent portfolio because it does stray from the original formula.  My biggest criticism of PRPFX, especially over the last few years, is its holdings of Swiss francs.  About 10% of the fund’s assets are invested in Swiss assets.

This doesn’t make a lot of sense to me because gold is in the portfolio and is supposed to protect your portfolio from dollar depreciation.  You shouldn’t need to invest in foreign currencies.

This was made worse in 2011 when the SNB announced its peg to the euro.  I don’t understand why the managers with PRPFX kept Swiss francs as part of the portfolio.  It may as well have invested in euros, at least up until this past week.

Well, things have just gotten a bit better.  It is no surprise that PRPFX did well last week with the SNB announcement.  I still think the fund should get out of the franc, as it is really speculation to buy foreign currencies.  Again, the significant gold portion should protect your portfolio against massive inflation.

At least now I feel a bit more comfortable recommending PRPFX.  While it is still far from perfect (nothing is perfect), it is a good option for investors looking for wealth protection and growth, without having to buy the individual pieces of a permanent portfolio.  It also does the rebalancing for you.

I don’t expect any more major announcements from the SNB, but the market will have to find the new exchange rate for the franc.  There may be some more volatility in the short run.

Overall, this is good news for people living in Switzerland.  It is also good news for those invested (or wanting to invest) in PRPFX.

With retail sales numbers coming in weak earlier today, stocks were down significantly.  But the more interesting story is how low the 10-year yield has gone.  It closed at 1.84%.  It briefly dipped below 1.8% during trading.

I believe this is an indication of a coming recession.  I have been cautious to call a recession too soon and I still don’t know how long this will take to play out.  But I am trying to warn my readers that they should prepare for a significant downturn in the economy.  You can never fully prepare, but it helps if you have an idea of what is coming.

The Fed stopped its massive QE program at the end of October.  We have had a couple of months of relatively stable money from the Fed.  It is rolling over maturing debt, but not adding to its balance sheet.

Yet long-term rates are dropping.  This means it is coming from investors, as opposed to the central bank.  This means that investors are locking in rates, even below 2% for 10 years.  The yield curve is flattening.

An inverted yield curve – where longer-term rates are lower than shorter-term rates – is typically a very good indicator of a coming recession.  In our present situation, short-term rates are near zero.  So we are unlikely to see an inverted yield curve.  For me, this flattening is good enough to indicate a substantial weakening in economic activity.

This should come as no surprise to those familiar with the Austrian Business Cycle Theory.  We have seen huge monetary inflation over the last 6 years and now it has stopped.  If the Fed doesn’t start pumping more money soon, the malinvestment is going to become evident soon.  Resources have been misallocated, and without the new injections of money, the artificial bubbles will be revealed and will go bust.  This has already happened to oil.  It will probably happen to stocks.

Keep an eye on the 10-year yield.  It is good if you are getting a mortgage or refinancing.  It is probably not good if you are invested in stocks.

As of this writing, the price of a barrel of crude oil is less than $50.  The price sunk quickly in the latter part of 2014 and nobody knows where it will find a bottom at this point.

There are a lot of misconceptions about what is happening and what it means, as so often happens with any economic subject.

There are basically four factors to consider in the pricing of oil.  There is the supply of oil.  There is the demand for oil.  There is the supply of dollars (or whatever currency you are pricing it in).  And there is the demand for dollars.

To be clear, when talking about the supply of oil or the supply of dollars, the supply expectations for the future are a big factor.  You could have no greater supply of oil today, but if there were new discoveries coming online and the oil production was expected to double next year, then the price would fall quickly just on the news.

It is the same with the dollar.  If the supply of dollars were currently steady, but people expected the Fed to start creating trillions of new dollars next year, then prices would start going up right away, all else being equal.  That is why markets move on Fed announcements, as opposed to just the Fed actions.

So what is driving the price of oil down?  In all likelihood, it is probably a combination of all of these things in something of a perfect storm.  The supply (and expected supply) of oil is going up due to the shale oil boom in the U.S.  Also, an announcement from OPEC, and Saudi Arabia in particular, that it would not cut production, helped trigger the downward price, although the price had already been moving down.

It would not be surprising if the demand for oil is down globally.  China has been slowing down a bit, not counting the stock market there.  Japan and much of Western Europe are in recession or worse.  So it makes sense that demand might be down for energy.

In terms of the dollar, the money supply has leveled off since the Fed ended its QE (money creation) program at the end of October.  This means that the money supply is expected to stay relatively flat in the near future, barring a major policy shift from the Fed.  This can also contribute to raising the demand for dollars.

Some might object to the dollar being a cause of declining oil prices because other prices are not going down.  Stocks are mostly booming (not counting the last couple of weeks) and consumer prices are not falling in most areas.  But here, it is important to understand the effects of monetary policy.  It is never uniform, which should be obvious based on recent history.

There was a tech stock boom in the late 1990s that went bust.  There was a housing boom in the 2000s that went bust.  These areas saw much of the monetary inflation rush into these sectors.  Therefore, they were also the sectors that crashed the hardest when it came time.  This is why I am very cautious about the current stock boom.

One thing that is important in all of economics is to not confuse cause and effect.  Low oil prices might be indicating a recession, but this doesn’t mean it will cause a recession.  Oil prices started declining in the summer of 2008 before most people knew we were in a recession.  It is quite possible the same could be happening here.  Or it is possible that it is just the weak global demand from the many major countries in the world that are in recession.

There are some people out there who think that falling oil prices are a bad thing, but not because it is a possible warning sign of a coming recession.  They think it is bad because it is hurting the oil business in the U.S., which has some high paying jobs.  But this is bad economics.  We should celebrate falling oil prices, unless you happen to be an employee in that sector or a major investor.

If the price of oil dropped to one dollar per barrel, it would be great.  We could fill up our cars for almost nothing.  It would be bad in the short run for some investors and employees, but resources would have to be reallocated to be more efficient.  This would include some employees having to work in a different sector.

As an individual, you should take advantage of the low oil prices.  If you are like the average American, you should be saving about 50 dollars per month at the gas station.  Maybe you are saving more.  Take your savings and pay down debt or contribute to your savings/ investments.  The low prices may not last.

I am very cautious about the overall economy right now.  The Fed has tightened and I believe that much of the so-called recovery of the last 6 years has been artificial due to the loose monetary policy of the Fed.  The 10-year yield is just under 2% right now.  With oil also low, there are a lot of warning signals.  But as long as things hold up in the U.S. and oil prices stay down, take advantage of the situation and add to your savings.