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The Fed's Presumed Inflation—Mostly a Mirage

By Susan C. Walker
Fri, 08 Jan 2010 16:15:00 ET
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The Fed has expanded the U.S. monetary base by more than 150% since the beginning of the recession, thereby assuring inflation, according to many analysts and basic common sense. But hold your horses—even though we agree that the Fed's actions will eventually bring on inflation, our near-term forecast is for deflation first, based in part on the credit implosion the U.S. economy is now experiencing. In fact, a stark sign of the inability of the Fed to keep people consuming appeared on Jan. 8, 2009, in figures that the Fed puts out. Consumer credit dropped for the tenth straight month, contracting another $17.5 billion in November 2009 (the latest month available). Bloomberg points out that 10 months is the longest stretch of contracting credit since the Fed started keeping the data in 1943.
But, still, how about all that extra money sloshing around that the Fed has created? Bob Prechter explains why the Fed's actions are more likely to create an inflation mirage rather than the real thing in this excerpt from his latest Elliott Wave Theorist.
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Excerpted from The Elliott Wave Theorist, December 18, 2009
The Fed’s Presumed Inflation Since 2008 Is Mostly a Mirage
Many commentators talk about inflationary forces running rampant. We all know that the Fed created $1.4 trillion new dollars in 2008. It has told the world that it will inflate to save the monetary system. So that is the news that most people hear.

But the Fed’s dramatic money creation in 2008 only seems to force inflation because people focus on only one side of the Fed’s action. Even though the Fed created a lot of new money, it did not affect the total amount of money-plus-credit one bit, because the other side of the action is equally deflationary.

When the Fed buys a Treasury bond, net inflation occurs, because it simply monetizes the government’s brand-new IOU. But in 2008, in order for the Fed to add $1.4 trillion new dollars to the monetary system, it removed exactly the same value of IOU-dollars from the market. It has since retired some of this money, leaving a net of about $1.3 trillion. So investors, who previously held $1.3t. worth of IOUs for dollars, now hold $1.3t. worth of dollars. They are no longer debt investors but money holders. The net change in the money-plus-credit supply is zero. The Fed simply retired (temporarily, it hopes) a certain amount of debt and replaced it with money. In fact, if the Fed is to be believed, it desperately wants to sell the rest of these (in)securities and retire the new money. I doubt it will happen, but it doesn’t much matter to inflation either way.

In currency-based monetary systems, the creation of new banknotes causes—indeed forces—inflation. Likewise, the monetization of new government debt creates permanent inflation practically speaking. (Theoretically, the government could retire its debt, but it never does.) But when the Fed simply swaps money for previously existing debt, there is no net change in the amount of dollar-based “purchasing power” on the planet.

The theory among monetarists is that these new dollars are hot money that creditors can now re-lend. Thus, it will multiply throughout the banking system. At first it might seem that new money in banks’ hands should be more powerful for creating inflation than the previously-held FNM mortgages. But this is not the case, because the main thing for which the Fed wants banks to lend out the new dollars is new mortgages. Today, bankers and other creditors are afraid of mortgages, and they don’t want new mortgages any more than they want the old ones. In the mortgage-intoxicated, pre-2008 world, there would have been little significant difference in the paper, because banks were creating new dollars any time they wanted by taking on new mortgages. In the mortgage-repelled, post-2008 world, guess what: there is still little significant difference in the paper, because virtually the only thing banks can use it for is to fund mortgages! The only other outlet for the Fed’s new money is to fund market speculation, which is one reason why the stock and commodity markets rose.

What is very different—as predicted in Conquer the Crash—is the desire of lenders to lend and of borrowers to borrow, which has shriveled dramatically. This abrupt change resulted from the change in the trend of social mood at Supercycle degree that took place between 2005 and 2008, when real estate, stocks and commodities peaked along with the ability of the banking system to write one more mortgage without choking to death.
The bottom line is that the Fed hasn’t created much inflation over the past two years. The only reason that markets have been rallying recently is that the Elliott wave form required a rally. In other words, in March 2009 pessimism had reached a Primary-degree extreme, and it was time for a Primary-degree respite. The change in attitude from that time forward has, for a time, allowed credit to expand again. But the Fed and the government didn’t force the change. They merely accommodated it, as they always have. They offered unlimited credit through the first quarter of 2009, and no one wanted it. In March, the social mood changed enough so that some people once again became willing to take these lenders up on their offer.

Find Out How the U.S. Government's Actions are Contributing to the Deflationary Picture.
Bob Prechter's latest Elliott Wave Theorist, published December 18, 2009, reviews the markets for the year and then launches into Part 2 of "Continuing -- and Looming -- Deflationary Forces." This time, he focuses on the government's unwitting role in ensuring that deflation will rule the U.S. economy. Find out more about the issue here.

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