Where is Inflation? 

The classic economic short-hand definition for inflation is when you have "too much money chasing after too few goods."  In other words, the more money that you pump into an economy AND the faster that money is spent the more likely you are to have inflation.  Many wise consumers are worried about the impact of the Federal Reserve "printing" too much money through its various quantitative easing measures since the Great Recession.  After all, the Federal Reserve has expanded its balance sheet by trillions of dollars in an effort to stimulate the economy. 

Consumers are naturally worried about the impact of inflation because the classic definition indicating inflation includes the phrase “too much money.”  It is true that too much money is one of two causes of inflation.  However, that money actually has to be spent in the economy in order to create inflation.  As an economics major, I spent many days living on a two person island during class.  So let me take you to a two person island for a quick example. 

You live on a two person island with me.  You and I both have $1.  I have lots of sunglasses and you have lots of sunscreen.  I decide that your sunscreen is worth $1 dollar so I give you a dollar and you give me X units of sunscreen.  You think it is a fair deal because you want to have two dollars rather than the $1 that you had.  Later that week, you decide that you want some of my sunglasses and you give me $1 for X units of sunglasses.  I am happy because I like having my dollar back.  We go back and forth like that for a while and we feel that price is at equilibrium.  

Now one day you and I discover $18 has floated up on shore.  You find $9 and I find $9.  The impact of the new money can be quite obvious.  You could tell me that X units of sunscreen is now going to cost me $10 rather than $1 dollar.  Boom - inflation just increased my costs from $1 to $10.  There was more money in the system and now inflation occurred.  

However, what happens if I decide that your X units of sunscreen are not worth $10.  I want to keep my $9 and since $1 dollar will not buy X units I decide that I don't want any units.  Instead of using your sunscreen, I decide to sit in the shade during the day and learn to fish at night.  I am essentially saving my money and not spending it (sound familiar to today’s economic woes).  Sooner or later, you decide that because the consumer (me) is not spending money the price should be more reflective of the demand.  Therefore, you lower the price of X units back to $1 dollar.  At that point, I become interested and buy your sunscreen again.  

That is the result of too much money in the system that isn't being spent and therefore is not creating inflation.  Does that sound familiar?  Haven't we seen household debt decline over the course of the last 5 years?  In essence, paying down debt is a function of savings.  In other words, the Federal Reserve is pumping a lot of money into the system but it isn't being spent in the economy by the consumer.

Now the risk of inflation is clearly there because there is a bunch of new money in the economy.  However, until consumers start spending it on their islands we are unlikely to see inflation being a BIG impact in the economy.  

Let me state the obvious.  We don't live on an island with just two consumers.  We live in a dynamic global economy.  Our prices are impacted by a number of inputs and the emerging consumers of China, India, Brazil and many other economies.  In addition, the above example is a gross simplification.  While it is useful to oversimplify in cases, it also highlights many false cross assumptions.  However, the basic outcome is the same.  There is a lot more money in the economy right now but consumers just aren’t spending it fast enough to create inflation.