Presumed Inflation...Really?

The following paper has been making the rounds in the blogosphere and I thought I'd throw in my two cents (all emphasis is mine).

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.
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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.

Frankly, I'm not an economist by training (even though I've studied the subject a bit) but I don't understand this one bit. Maybe I’m slow but this makes absolutely no sense to me. I don’t see how the Fed purchasing the Treasury’s debt is not simple monetization and, therefore, inflationary. Debt holders become money holders (money that was not previously in the system). So, with actionable money they can buy more debt. Doesn’t that support prices and isn’t that inflationary? Whether the Fed buys existing debt or new debt doesn’t seem to matter if the Treasury is issuing debt all the while.

So, granted the money doesn’t go into new debt because no one wants to borrow (the consumer is smartening up and deleveraging). So, “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.” Isn’t this inflation…the pushing up of asset prices with new money?

The Fed has created huge inflationary pressures in the system. The idea that the data have not shown inflation and, therefore, the actions haven't been inflationary is nonsense. Prices should be deflating much further than have been allowed by the Fed. If anyone can explain to me how the Fed's actions have not been net inflationary I'd love to listen. If Prechter actually is right, then the Fed is pretty worthless at stabilizing prices, one of its two core mandates.