Where Was the Inflation?

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Includes: DIA, IWM, QQQ, SPY, UDN, UUP, XLF
by: Dirk McCoy

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.