The Inflation myth

Markets have rallied substantially of their previous lows. It appears that many market participants are rationalizing this with inflation expectations, which in the most extreme form turns out something like this:

The rationalization appears to be as follows: The FED has pumped Trillions into the financial system, so they must eventually pop up somewhere and produce inflation. Monetary expansion always fuels inflation does it not?

Well, basically, no.

The Fed has pumped trillions into the financial system. However, this is not effective monetary expansion but merely bank credit lines to pay for previous losses that have occurred due to last years repricing of risk in the credit markets. This pumping does not expand the money supply in the real economy, but merely buffers the shrinking of the money supply which is occurring due to financial system deleverage and writeoffs.

More precisely, the expansion of the FED balance sheet is largely due to the provision of "short term" liquidity to distressed financial institutions. Despite the concerted effort of the US government, the financial system remains severely stressed.

US consumers have been living off debt. Now it has been noted that this is unsustainable, credit lines are being cut: deflation, unless the FED effectively nationalizes the banking system by the backdoor to increase credit, which would be insane - not to mention illegal. The FED is stuck between a rock and a hard place, and is desperate to produce confidence so that defaults will not rise even more.

However, they appear to have forgotten that there is a relation between confidence and the real economy. The real economy remains unfixed. When the financial system delevers (which it must! - even Ben would have to agree on that), this is what you get:

Indeed, I agree that the current irrational exuberance is partly due to inflation expectations, and partly due to manipulation. Inflation expectations do to some extent drive effective inflation. However, in this case the inflation expectations are fighting an extreme crisis in the financial system, and a growing crisis in the real economy.

While layoffs continue, and people feel poorer whilst their credit lines are being cut, there is no driver for house prices to stabilize. Indeed, the premature confidence building is likely to cause greater difficulties down the road as people get poorer for being whiplashed twice in the stock exchange. I gather however that the treasury and the fed have decided that it is first necessary to recapitalize the financial system on the back of the sheeple (expect plenty of short prop trading in the summer or early autumn just as some "catalyst" causes markets to plummet again (this will be orchestrated via earnings, expensive oil, swine flu...).

Real inflation is impossible to produce whilst private and corporate credit lines are cut, especially in a consumption driven economy. The only driver for inflation will be the drop in the value of the dollar, however this will not bode well for indices as companies will suffer more in the aggregate given the bloated retail/consumption sector.

In case you need another example for what happens in a debt-deflation scenario:

The only real difference being that this time the problem is global, and there is no external growth area to export to.

In my analysis this is going to be brutal. So lots of Japan before we get anything close to Zimbabwe.