When it comes to the overall economic picture, sometimes it is a good idea to take a step back and look at the big picture.

I am a firm believer in the Austrian Business Cycle Theory.  You can call it whatever you want, but when a central bank creates money out of thin air and releases it into the economy, it has its consequences.

It may not mean significantly higher prices right away – or at all if judging by recent history – but it misallocates resources.  It translates into capital going into certain sectors than it otherwise would have.  It means that production is lower in terms of meeting consumer demand.

With loose money usually comes lower interest rates.  This policy is especially bad because it discourages savings and encourages more debt.  Interest rates are an important mechanism (price) in our world, as they basically tell us the price of money.  When there is a shortage of savings, higher interest rates will draw people into saving more.  The free market is self-correcting.

The problem is when the central bank and government distort interest rates.  It sends false signals, which can contribute to the artificial booms and the subsequent busts.  Artificially low interest rates mean less savings, even if more saving is needed in the economy.

One thing we know from the Austrian Business Cycle Theory that can help us with predicting the economy and helping us with our investments is that loose money and artificially low interest rates will cause unsustainable bubbles/ booms that eventually go bust.

The Fed (or any central bank) does not need to stop its loose monetary policies in order to bring on a bust.  At some point, a bust becomes inevitable unless the central bank continues to accelerate its rate of money creation.  If the central bank keeps accelerating its monetary inflation, then you will eventually end up with hyperinflation and a bust that is far worse than any other.

So what is the status of our present situation?

Since there are billions of moving parts in the economy, we can’t know precisely what has happened and where we are.  But we can still take a look at the big picture.

Since the fall of 2008 (the word “fall” has two meanings here), the Fed has increased the adjusted monetary base by five times.  In normal circumstances, one would expect this to cause massive price inflation.  But in our crazy economic world of the last decade, most of this newly created money went into bank reserves, thus helping keep a lid on price inflation.

While the federal funds rate still sits near zero, the Fed’s monetary policy has actually been tight for about a year now.  It was just over a year ago that the Fed announced the end of its latest round of quantitative easing.  This was the end of QE3.

Under normal circumstances, we should expect a recession to be coming soon.  The Fed has stopped the flow of new money, so there should be an inevitable bust.  The problem we face is figuring out how big and when.

The massive excess reserves built up by banks makes this much trickier than in the past.  If banks continue relatively tight lending (at least compared to a decade ago), then a recession may be close at hand.

But what if the banks start lending out more money?  All of a sudden, this cancels out the Fed’s tight monetary policy.  It could actually mean inflation while the Fed sits on its hands.  It would be inflation via fractional reserve lending.

In this sense, the Fed’s interest rate policy is somewhat important.  If the Fed does raise interest rates, it can only feasibly do so by increasing the rate it pays on bank reserves.  If it does this, then this will just encourage banks to keep a lot of money locked up in reserves.

For this reason, I tend to lean more towards seeing a recession within the next year rather than later.  That is with the assumption that the Fed does raise the federal funds rate, even if gradually, and it also assumes that the Fed doesn’t start another round of quantitative easing.

We have already seen a bust in the oil bubble over the last year and a half.  Remember that the price went from about $100 to $40 in a relatively short time period.

I think the most vulnerable bubble now is in stocks.  But in some ways, I don’t really care too much about stocks.  I care about stocks more as an indicator than I actually care about stock valuations.

What matters most to most people is the employment picture.  If we hit a recession, unemployment is likely to rise again.  Wages are likely to go down.

It is important to remember that corrections are needed when the damage has already been done.  I can see that the American middle class is struggling tremendously.  Wages are not keeping up with expenses.  This in itself points to a necessary correction.

Recessions (corrections) hurt because some people lose their jobs.  But the unemployment is a result of the previous misallocation of resources.  The correction is needed to put those resources to their proper uses.  The correction also has the benefit of lowering expenses for most people.

We will keep an eye on what the Fed is doing.  More importantly, we will keep an eye on what the banks are doing.  If the Fed keeps monetary policy tight and the banks do not expand lending, then we should expect a recession in the somewhat near future.

Still, we can’t time the Austrian Business Cycle Theory.  Sometimes these things take time to unravel.  It takes a while for the mistakes to be realized by the marketplace.