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First, Let’s Define Inflation
In economics, inflation is defined as –
“A general increase in prices and fall in the purchasing value of money.”
Background: 2008 Financial Crisis
The 2008 financial crisis brought the global economy to its knees and is now known as the Great Recession. To avoid an all out depression, global central banks decided to take unprecedented measures to help the economy and capital markets recover. In short, they decided to flood the system with liquidity and print billions, no trillions, of dollars to help stimulate both Main Street and Wall Street.
Risk vs Reward To Central Banks “Easy Money” Stance:
Inflation or Reflation
Every decision we make (or don’t make) has consequences. There is an old saying- we are all free to make (or not make) certain choices, but we are not free from the consequences. The decision to flood the system with liquidity (print money) was unprecedented. There was no way to know for sure what the consequences would be for a coordinated global central bank effort to stimulate the economy and reflate asset prices. The biggest risk at the time to printing trillions of dollars in new money was that this massive stimulus effort would lead to hyper-inflation (uncontrollable inflation).
Federal Reserve’s Balance Sheet
In the 5.5 years following the 2008 financial crisis, the U.S. Federal Reserve (not to mention other Central Banks) has expanded its balance sheet by whopping $4.5 trillion dollars (yes, that’s trillion, not billion). Meanwhile, inflation remains below the Fed’s 2% target. The obvious question is why? Before I answer that question, it is important to note that the entire 5.5 year recovery has been lackluster at best which has also baffles economists.
Let’s Solve The Big Inflation Mystery:
3 Reasons Why Inflation Remains Low
From my point of view, there are a few reasons why inflation remains a nonevent for the U.S. economy (and most of the western world for that matter).
1. First, the economic recovery remains anemic at best. In a slow economy, demand is weak. That means a lot of people are NOT aggressively chasing prices and therefore there is no need for prices to rise. As a result, people selling goods/services are incentivized to lower prices (we are seeing this in many popular retailers) to attract buyers. Hence, no inflationary pressures.
2. The second crosswind is a lack of trust. Put simply, people (consumers and businesses) have lost trust in the “system” and are hoarding cash- even though interest rates are extremely low.
3. The Commodity Super Cycle has ended. In the first decade of the 21st century, the global economy experienced long commodity super-cycle. A commodity super cycle occurs when commodity prices soar and remain “high” for a new time. The best example of this can be seen in the price of gasoline. Ten years ago, in 2003/2004, the average price of gasoline was $1.5-$2, in 2014 it is around $3.50. Prices for most commodities have stopped moving higher and have actually spent the past few years moving sideways to lower (2010-2014). The fact that commodity prices are not moving higher is another reason that inflation remains at bay.
These are just three reasons why inflation has not been a “threat” for U.S. economy since the 2008 financial crisis.
Why Central Banks Are Still Printing Money
As previously mentioned, every decision has consequences (risk vs reward). Let’s analyze the risk/reward ratio from a central banks point of view. The biggest risk to printing more money is inflation and the rewards are a stronger economy and stronger capital markets. Since inflation is not a threat (right now) and economic growth remains weaker than most would like- Why wouldn’t central banks keep on printing? More info on SarhanCapital.com
What This Means For The Stock Market
One could argue that the primary driver for this entire 5.5 year very strong bull market has been easy money from the Fed/ other central banks. Since 2009, the S&P 500 (SPX) soared whenever the Fed has been printing money and fell -17% and -21% respectively when QE 1 (quantitative easing) & QE 2 ended. We’ll see if this time is different. Until something changes, this bull market is alive and well.