Fed Watch: Inflation and M2

The Fed's most recent release of it's balance sheeet is not very consequential.  After all, it is published every week.  How much can change in a week.  Not too much, although, the Jan 21st purchase of 49BB in balance sheet did look a bit fishy.  Short term is important, but the long term trend is more important. The Fed has increased it's balance sheet almost $395 Billion over the course of the last year (see http://bit.ly/bmBwxn).  How has this affected inflation? 

First, a mini discussion on what inflation is and what it isn't.  CPI numbers are not inflation.  It is a byproduct of inflation.  Inflation is an increase of the money supply.  The best way to think about it is, if there is more money in the economy, it has to go somewhere.  It can either be placed into consumption, in which case it shows up in CPI/PPI numbers, or it goes into financial assets, in which case bubbles form. 

That is how the Fed screwed up in early 2000.  Inflation was rampant.  The money went into financial assets, mostly real estate.  So the biggest expense most people make in their lifetime went up threefold in many cases, but since bacon did not, the Fed said "no inflation".  The Fed does include a value in the CPI that measures rents as a proxy for mortgage payments.  But since rents did not jump to the extent that housing prices did, it remained largely unnoticed.  Inflation was rampant in early 2000, when measured as M2 increases.   Likewise now, we have been undergoing inflation from from the Fed, as it has increased the balance sheet by 1 trillion in the last 2 years (See http://bit.ly/aw9lhg).  We have had competing deflation in the housing market as money has been exiting in droves.    That is why the CPI numbers have not budged.  The current inflation is being partially offset by the deflating bubble.  Once the bubble is completely burst, then we should see increases in the CPI numbers. 

So year over year the Fed balance sheet has gone up by $395 Billion.  M2 has correspondingly increased by over $220 Billion.  Is there a correlation?  Hmmm...

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