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What Happened to Inflation?

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If it wasn't clear before, it is now: The pundits and analysts who predicted a massive onslaught of inflation thanks to the Federal Reserve's easy-money policies were wrong.

A report issued by the Bureau of Economic Analysis on Friday showed that, despite the Federal Reserve's now third round of quantitative easing, during which it's pumped $85 billion into the economy every month since last September, consumer prices are hardly budging.

Core prices, which exclude food and energy prices, rose only 1.1% in April compared with the same month last year. As Josh Mitchell of The Wall Street Journal observed, that matched the smallest increase in underlying prices since the agency started tracking them in 1960.

Putting ideological beliefs to the side, one can't help wondering how analysts and commentators, myself included, got it so wrong. And the answer is that many of us failed to fully appreciate the depths of our economic woes and the implications for the money-creation process.

Under normal times, it's fair to assume that the creation of $2.5 trillion (which is roughly how much the Fed's balance sheet has expanded since the third quarter of 2008) would indeed translate into higher consumer prices. This is simply a function of supply and demand. That is, by increasing the supply of dollars, you thereby decrease the demand for them -- which, in turn, drives down the value of each dollar and thus its purchasing power.

But as I alluded to, these are not normal times. Indeed, while the Fed is, in fact, trying to create money and thereby fuel inflation, the banks are stymieing its attempts.

Although the Fed is often accused of "printing money," the reality behind the money-creation process isn't quite so straightforward. As opposed to actually printing dollar bills and then, say, dropping them from a helicopter, the Fed expands the monetary base by purchasing financial assets from banks -- namely, Treasury bonds and mortgage-backed securities. By doing so, the Fed reduces a bank's yield on earning assets and thereby spurs it to offset the decline by lending more. The proceeds of said loans are then redeposited and lent out again in an ongoing and circular process -- something known as the "money multiplier" -- that eventually results in having a lot more money circulating throughout the economy.

The problem right now is that banks aren't responding as they theoretically should. That is, as opposed to increasing their lending, they're taking the proceeds from the asset sales and simply redepositing them at the Fed. This is what's known as a "liquidity trap," and the following chart illustrates the almost one-for-one expansion of the Fed's balance sheet with the growth in reserves held at the central bank.

Now, it's worth noting that the Fed's actions aren't entirely without consequence. As I've discussed previously, one result has been the staggering gains in both stock and bond prices over the past few years. To consider only the former, before the end of last week, both the Dow Jones Industrial Average (DJINDICES: ^DJI  ) and S&P 500 (SNPINDEX: ^GSPC  ) had reached new all-time highs. But despite the disproportionate amount of attention stock prices get in the financial press, they're a sideshow to the actual economy itself.

The point here is that the predictions of impending inflation over the [ast few years were wrong. If you're one of those who believed this line of thinking, I encourage you to (as I've done) re-evaluate and update your opinion.

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