Where Was the Inflation?

As we see credit destroyed in historic amounts, and as we see false wealth revealed by the billions, it is clear that the boom period from 2003 to 2007 was fueled by an incredible expansion of capital. It's reminiscent of a poker game where, when more guys show up to play and the host has run out of chips, all kinds of IOUs, chits, and promises get pulled in to keep the game growing.

This effectively created a huge expansion in money and wealth (some of it, arguably, false). And as every amateur economist knows, vast expansions in money translate to inflation- right? Yet, inflation was very much in control in this decade- increasing only slightly from a minimum of 1.6% in 2002 to a maximum of 3.4% in 2005, and then lower in 2006 and 2007. Housing prices soared, but this was to be expected due to the 1997 change in capital gains exclusions for home sales (doubled and liberalized) as well as the fact new houses are larger, more luxurious, and more efficient. So the question is, with all this money creation, where was the inflation?

The answer is simple. Inflation is only created when money supply growth outstrips supply. Remember the monetarist equation, M(oney) x V(elocity) = Q(uantity) x P(rice). As long as Quantity goes up at the same rate as Money, aggregate inflation is not a given. The price of some goods may increase (houses) while others decrease (garage sale t-shirts), based on relative utility and supply, but as long as goods and services are created to absorb more money, then inflation in general can be kept in check.

Where were these new goods and services created? Obviously, globalization has brought billions into the global labor pool. Also obviously, technology has increased productivity and yields. Less obviously, this technology has also allowed goods and services to be extended to places previously not economically feasible. One example is the use of the internet and credit scores to provide credit in smaller amounts to a larger group of people. Instead of meeting with a loan officer, going to loan committee, formal closing- these steps can be accomplished with a few keystrokes.

The question, then, becomes this: Why did the Federal Reserve raise interest rates 18 times between 2004 and 2006? Why did the rate go from 1.5% to 6%? Why did they raise the specter of mortgage payments increasing 50%+ for millions of ARM-financed home owners? And why did they increase the need for companies to increase their operating margins to free up not only the additional money for increased debt service, but also more profit so their cash flow to debt service bank ratios could be maintained?

As we now see, this has created a downward death spiral. Instead of new goods and services being created, goods and services are being destroyed. Instead of wealth being shared and invested, it is now being hoarded. And while the Federal Reserve and other central banks are trying to reflate, they're learning that the time to build is much longer than the time to destroy.

The lesson from this episode may be that fears of inflation must always be tempered with the realization that globalization, trade liberalization, technology, and the ability of consumers to change consumption patterns are powerful forces offsetting inflation- though they may take a bit of time to present. And, once this episode is over, these forces will remain just as powerful, if not more so. Perhaps the Federal Reserve governors will bear this in mind the next time they start to worry about economic growth and asset price increases.

Comments

[Balderdash:]

the inflation manifested itself in a unprecedented housing orgy

that's not measured by CPI

2008 Dec 14 08:38 AM

[prudentinve...:]

The inflation was in asset prices, causing unnaturally high ratios between value of assets and value of labor, causing the current nightmare!

2008 Dec 14 08:39 AM

[Prudent Man...:]

Like my cancer, because you can't see it doesn't mean it is not there. I didn't hear any of the market gurus talk about the derivative bubble that funded the real estate boom of 2002 with phony assets in 2006 and 2007, when the market was hitting new highs.

Inflation is there hidden in stagflation. When it hits you along side of the head you will know it and, as usual, too late. Socialist Obama will pour more money, with its attached graft, into the system providing useless work for his political cronies and we will get what FDR gave us, twelve years of depression. Some idiots call this leadership.

2008 Dec 14 11:16 AM

[happysoul77777:]

It's more like a deflation short-term. Everything is deflating right now!
After they fix the securitization process, inflation will surge back quickly.

2008 Dec 14 02:32 PM

[Robert Nabloid:]

"And as every amateur economist knows, vast expansions in money translate to inflation- right? Yet, inflation was very much in control in this decade- increasing only slightly from a minimum of 1.6% in 2002 to a maximum of 3.4% in 2005, and then lower in 2006 and 2007."

The vast expansion of money ended up inflating the price of homes! Most of that vast expansion of money was people taking on massive mortgages and bidding homes prices up! My parents home value almost doubled in one month! That's where the inflation went during this last round of money expansion. Only if you were blind could you have missed it.

I can't afford to buy a home due to all the home price inflation in my area. Now the home prices are starting to come back, but in my area they are still far above what they have been historically. Until they come back, the inflation in home prices is preventing me from buying a home. Don't act like inflation didn't occur - it did. You must have already owned a home and so it didn't affect you the same way it would a new immigrant or a 22 year old straight out of University with degree and student loans to repay. It's easy for me to see the inflation that was occurring, I would have to be blind not to see it.

2008 Dec 14 05:46 PM

[nmelendez:]

Used to be a house cost twice your annual salary. Thats why you had 20 yr mortgages. Now people buy houses 5 times their annual salary on 30 even 40 year mortgages. As long as people are willing to go broke over a home, houses will continue escalating in price.
A lull has been reached. Do not believe for one moment the party will not continue once the music starts again. It;s an ongoing musical. Me i got me a deal. jejeje

2008 Dec 14 08:42 PM

[Steven Hansen:]

"The lesson from this episode may be that fears of inflation must always be tempered with the realization that globalization, trade liberalization, technology, and the ability of consumers to change consumption patterns are powerful forces offsetting inflation- though they may take a bit of time to present. And, once this episode is over, these forces will remain just as powerful, if not more so. Perhaps the Federal Reserve governors will bear this in mind the next time they start to worry about economic growth and asset price increases."

Dirk, i would have agreed with you a few months ago before the Fed and the government (and Europe) started creating the most unstable monetary situation that mankind has ever known. Today, economic theory is worthless as we have entered territory that I doubt was ever even modeled.

2008 Dec 14 11:53 PM

[lookbeforeU...:]

Dirk - I am somewhat surprised regarding some of your comments in this post. To suggest that there has been relatively little inflation during the past few years is too ignore everything that surrounds you. Energy, all commodities, food, housing, vehicles - all experianced significant inflation during the last few years but most are not included in the government's CPI or have been nulified by some subjective determinations that the price increases were supported by perceived value increases in the products. Are you actually suggesting that goods & services during the past few years have been created in an amount that would have absorbed all the additional credit (money supply) that the real estate bubble produced? Your comments indicate that you believe interest rates should not have been increased by the FED during this time period, and it was that increase that resulted in the death spiral we are in today.

With all due respect - are you out of your mind? First of all, almost all commercial debt is tied to Libor rates, not the prime rate (which is directly affected by the FED's discount rate). Secondly, many companies purchase interest rate swaps that put ceilings on the amount of interest rate exposure they have on their debt. That insulates them from subsequent market interest rate increases. Of course, new debt issuances are subject to the current interest rates, but a company will not incur the debt unless the return on the investment from the debt proceeds exceeds a certain level based on the risk of the investment. Once that debt is issued, it is irrelevant what happens to interest rates. Third, non-ARM mortgage debt rates have nothing to do with the FED discount rate. Many property purchasers received no-documentation loans or borrowed downpayment amounts using HELOC's. The no-doc loans were actually more lucrative to lenders because securitizers would pay more for those than conforming loans, so many mortgage brokers actually pushed buyer's into those loans. They may have paid a little more in interest, but it was so easy to get such a loan with a good credit score. How about the HELOCS - you could buy a home with no money down and simply pay interest only on the first mortgage and the HELOC!!Once housing prices stopped rising and started downward due to the fact of oversupply and exhausted demand, it was obvious what would happen on these kinds of loans. Fourth, the fact that ARM's were obtained by borrower's in the first place is indicative of the speculative nature of the purchase - the ARM's provide a low teaser rate that allowed buyer's to qualify, but many could only have continued to pay the mortgage if rates never changed. Some even chose negative amortization ARMS, with the unpaid interest added to the loan balance - I can't imagine that any investor would but such a loan. In fact, at the time of purchase of the property, the applicable interest rate upon conversion of the ARM was already greater than the teaser rate. Many buyer's just ignored this fact - they assumed they could refinance using all the equity they would "earn" during the teaser period or they would just sell the house at an appreciated value.

Your post seems to advocate a Ponzi scheme - if the loans start to come under stress, simply lower interest rates for borrowers. When that no longer works, just have the FED buy the debt and do a workout for the borrower. Finally, the FED can just issue the debt directly to the borrower under whatever terms the FED needs to prop up the price. In your world, the asset bubble continues unabated until when? I'm not sure what your economic background is, but your naivete is astounding.

Inflation is the growth of the money supply at a rate that exceeds the creation of goods & services. More money, relatively, chasing fewer goods and services, causes inflation. Price increases are the result of inflation. Increases in the value of a house or other real estate does not result in an increase in wealth and is not equivalent to the creation of goods and services. Increased productivity should have no affect on the price of existing homes, and should only increase the price of new homes in an amount equal to the value of the productivity increase. No serious economist would argue that the 10 - 25% annual increases in home prices per square foot were supported by increased productivity. Ultimately, the credit markets burst the bubble, but the mortgages had been securitized and then split up into tranches and sold through REMICS, with the non-investment grade tranches resecuritized and sold in another REMIC and so on and so on..... That is why we are facing the "death spiral" because there is no easy way to deal with the toxic debt due to the contracts the REMIC's have with the servicers and the fact that the tranches were sold all over the world.

If I misread the premise of your post please forgive me - if I haven't, then good luck with convincing the FED governors to bear your thoughts in mind when the next asset bubble appears.

2008 Dec 15 03:25 AM

[Tony Daltorio:]

The author obviously does not understand that there is another type of inflation which does not appear in the CPI. Can you say asset price inflation?

2008 Dec 15 01:03 PM

[SpinWatch:]

Dirk-excellent article. The answer to your question is at winningoverbarriers.co...

2008 Dec 15 03:54 PM

[Dirk McCoy:]

Thank you for the comments.

Regarding housing- note that rent prices did not increase as much as home values - there was never a shortage of housing. Also bear in mind that immigration to this country was very strong- and there were still plenty of places for them to live. I believe this supports my statement in the article that tax code changes, size/quality of homes, and ease of financing were behind this boom.

The problem with controlling asset booms via interest rate manipulation is that you throw the baby out with the bath water. The jobs that go into building and improving homes, appraising, financing, selling, moving- are also negatively affected. Why- so the price of car spaces in Manhattan can drop?

Meanwhile, a good thing- more housing- becomes a bad thing? Sure, the commercial real estate segment will suffer as more people use these larger homes for home offices and home business product storage. Is this a negative development? Or is staying at home, and driving less, actually a positive development?

While there are those who want to make these value judgements and then see them implemented by measures to "cool down" an "overheated" economy, I prefer the market have the opportunity to make these judgements, and then have confidence to respond without having to worry if the Fed will increase their cashflow requirements by a factor of 2 or 3X.

Jan 06 08:16 PM