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Last week I read an article here by fellow contributor The Market Flash titled "Why Inflation Never Came." I had been mulling over a similar article for a couple of days so my first thought was "I was beat to the line." After reading his compelling arguments for why we never really saw inflation, I thought that my argument was still valid, and would work alongside his. While his argument is strong, I believe that there is a simpler answer to why we never saw inflation.

The M*V=P*Y (the Quantity Theory of Money) framework is what many investors and economists have been working from. I can almost guarantee you that if you have taken an economics class this formula was on your first page of notes. In an Econ-101 world you hold the velocity (V) and, since we're talking about monetary policy here, the output (Y) is also constant, because monetary policy can't change the factors of production. So that leaves us with M=P, where M is the money supply and P is the price level. Intuitively you would think that Quantitative Easing, which is referred to no less than 500 times a day as increasing the money supply, would cause inflation. But inflation never came.

In the quantity theory of money M is the money supply. The Fed doesn't actually control the money supply, it only controls the monetary base. If the Fed could control the money supply, the size of QE3 would have been causing some inflation. This is the Personal Consumption Index, which is what the Fed uses to measure where it is in relation to its inflation targets. They don't look at CPI, like it is commonly thought. The difference between the CPI and PCE is that the PCE measures total expenses, which weights healthcare more heavily. For example if you go to the doctor for a yearly physical and your co-pay is $100 and the insurance pays for $100 then the total cost is $200. CPI would only count the $100 co-pay, while the PCE would account for the total $200.

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The Fed can't do anything to the money supply, only banks lending can do that. The conventional wisdom is that Fed printing money will cause the banks to lend, creating a money multiplier, and the lent money will then chase goods, creating inflation. The truth is that the Fed simply provides liquidity, which cheapens the cost of credit.

The problem is with how people imagine quantitative easing and really monetary policy in general. The problem is that many people equate printing money to an increase in the money supply. The reality is that there is absolutely no correlation between these two things. This chart from a piece by Peter Stella, yes that Peter Stella of Singh and Stella fame, shows the relationship between base money and inflation.

(click to enlarge)

As you can see, there is very little correlation between the growth rate of money and inflation. This misconception, combined with not many people understanding the finer points of monetary policy and the increase in money supply versus the monetary base is why we saw Gold (NYSEARCA:GLD) and Silver (NYSEARCA:SLV) sell off so sharply. When people heard the Fed was implementing a third round of quantitative easing, they thought that the size and open ended nature of it would certainly cause inflation. If people would stop equating money supply with monetary base and really understood how the Fed implemented monetary policy then they would have a much easier time investing, especially in regards to precious metals, which have historically been an excellent inflation hedge. Like "The Market Flash" I don't anticipate us seeing inflation anytime soon, and I don't think the Fed does either. So what should you expect?

I think that the first thing we will see is the dollar strengthening. Even before QE ends the dollar will continue appreciating. The reality is that with every country with a central bank pursuing some form of quantitative easing, even talks about the U.S. tapering will then make the USD the prettiest girl at the bar. Then, not soon after, treasury yields will begin ticking up. Then, once the risk taking that we have begun to see take place in the financial sector spills over into the real economy, that is when we will see inflation.

Source: The Real Reason Inflation Never Came