With all of the problems we have had with bubbles lately, the dot-com bubble, the housing bubble, the commodity bubble, etc., the last thing you would think we would want is yet another bubble. But it looks like we might be getting one, this time in the stock market.
The market is up over 50% since its April low. While some corporate profits are up, the increases are, in many cases, the result of cost cutting instead of increased economic activity. That doesn’t seem like a solid basis for growth, either in the economy or in the stock market.
Over the last 12-18 months, the Federal Reserve has flooded our economy with money. They lowered short-term interest to just about zero. They have undertaken all kinds of new measures to create additional liquidity in the market. This was necessary. As the velocity of money slowed, the increase in liquidity helped keep the effective money supply from contracting. With the conditions we had last fall and this spring, that was important. A significant drop in the money supply could have turned a bad recession into something much worse.
But eventually the increase in liquidity, if it continues, is going to cause an increase in the effective money supply. It may even be doing it now. And if the money supply goes up, prices will go up – at least to the extent that the money supply goes up faster than the supply of goods goes up. Here is one way to think about it (very simplistically). The price of goods is equal to the amount of money in the economy divided by the amount of goods. If the amount of money goes up more that the amount of goods, the result, the quotient, goes up. If there is nothing stopping a general price increase, i.e., an increase in the prices of all goods and services, then you will have an increase in general inflation. It would be like this:
B: --------------------------
^ ^ ^
^ ^ ^
A: --------------------------
When the money supply increases more than the amount of goods, prices go up from A to B.
But sometimes there are outside reasons why some prices cannot go up or why it is easy for others to go up. In the early 2000s, the Federal Reserve increased the money supply by dropping interest rates and keeping them low for a long period of time. The Fed was reacting to the attacks on 9/11 and the leftover effects of the bursting of the dot-com bubble. At that time, Chinese imports were keeping a lid on consumer prices. Therefore, the money had to go somewhere else. Some of it went into the stock market – remember the Dow at 14,000? The rest of it, a lot of it, went into housing. It went into housing two ways. Some of it went into housing as an increase in prices. The rest of it went into housing as lending to home buyers. All kinds of "innovative" (a/k/a wild and crazy) kinds of loans and lending practices were devised to increase the rate of return for lenders while keeping borrowing costs low for home buyers. Which worked as long as house prices kept going up. Which they didn’t.
In the face of the bursting of the housing bubble and the near-financial panic after Lehman Brothers went bankrupt, the Federal Reserve dropped interest rates (like a rock) and pumped liquidity into the financial markets (like there was no tomorrow – because they were afraid there might not be).
Now, with GNP dropping and unemployment rising, the Federal Reserve is keeping interest rates near zero and has continued to add liquidity to the economy. As I mentioned above, when the velocity of money slows down (as it did), pumping liquidity into the economy will not result in an increase in the effective money supply since what ultimately counts is the product of the amount of money times its velocity. However, as the velocity of money picks back up, the effective money supply goes up. And that money has to go somewhere. In normal circumstances (as the diagram above shows), the result is a general increase in inflation.
However, we do not have a normal situation today. Consumer prices cannot go up because of continued pressure from Chinese imports and a combination of excess capacity and high unemployment in the United States. Housing prices cannot go up because of a glut of unsold houses on the market and a tightening (at least by private lenders) of mortgage lending standards. But the money has to go somewhere, so where does it go? To the stock market. And so we have today’s situation, where housing prices and consumer prices can't go up, so the increase in the money supply raises the prices of stocks:
.................. Stocks
.................. ^^^
B: Housing..... ^^^ .....Consumer Prices
A: -------------------------------------------
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