History has shown us time and again that out of control money supply expansion creates inflation. In light of the trillions of synthetic dollars that have been injected into the economy by the Federal Reserve over the past five years, most observers (this one included) had expected prices to spiral upward. But in making these determinations, many of us forgot to factor in the supply side of the supply/demand equation. Inflation remains low now because of game changing events that have reduced the demand for money.
As far as the Federal Reserve and the President's Council of Economic Advisors are concerned, inflation is currently holding at around 1.4 percent. However, these authorities choose to focus only on the most generous measurement tools, like the core PCE index. Other common indices, such as the CPI burn much hotter. Current CPI is at 2.9 percent, the highest year-over-year increase since 2008 and more than twice the rate of the core PCE. However, it is widely recognized that even these figures have been manipulated downwards to benefit the Government.
Many more skeptical observers suspect that the real rate of inflation is far north of 6 percent, perhaps closer to 10 percent. But even this figure is far below the rate of expansion that our money supply has undergone over recent years. As of November 17, 2011 the Federal Reserve reported that the U.S. dollar monetary base has increased by 28 percent in just 2 years. Logically we should expect to see a direct correlation between the money supply and the rate of inflation. What explains the breakdown of this relationship?
The dramatic collapse in the real estate market, and the resulting recession and deleveraging, have created a very different dynamic among many consumers, businesses and banks. The fragile economy and lagging global uncertainties have inspired dramatic removal of risk, thereby slowing the circulation of money. The dimming of animal spirits should act as a weight on the general price structure. Put simply, a recession should push prices down.
The savings, retirement accounts, and real assets of consumers suffered massively in the recession of 2008/9. Cash flow shortages drove many companies into liquidation. Banks that had speculated in real estate or had made irresponsible so-called covenant-light loans had to be rescued by the taxpayer or by other more conservative banks. Therefore, corporations and banks joined consumers in becoming far more conservative. Indeed, although banks are stuffed full of deposits, bank finance remains extremely tight.
Before the crash, many consumers and corporations had grown accustomed to the continual growth of asset prices. Therefore they grew comfortable with leverage as a means to safely increase wealth. Even banks shared this sanguine view.
Today, consumers have become conservative, spending mostly on what they see as essentials.