The Fed’s Deflation Illusion

Imagine you are living on a Pacific island.

The currency is cowrie shells and there are 1,000 of them circulating around the island economy. You own a fishing boat which is worth 10 shells, or 1% of the total money (cowrie shell) stock. But then fishing suddenly becomes out of favor and you find that, if you wanted to sell your fishing boat, people would only be willing to pay you 5 shells for it (0.5% of the island’s money stock). The price of your asset has deflated.

The chief of the island, though, likes fishing and doesn’t want to see the price of fishing boats decline. He decrees that more shells shall be found for the island and, after a while, another 1,000 shells are found and added to the island’s economy. The island now has 2,000 shells in total. The lower demand for fishing boats, though, is still the same, amounting to the equivalent of 0.5% of the total shells on the island. The difference now is that 0.5% of the money stock amounts to 10 shells (0.5% of 2,000). That’s the same amount of shells your boat was originally worth before the great fishing boat crisis (GFbC). You are happy and hold the chief in great reverence for such a wonderful decision to increase the stock of shells (money).

The chief likes this praise and so decides to keep searching for shells. After a while, another 1,000 are found and added to the economy. Underlying sentiment towards fishing, however, still hasn’t changed and people are still only willing to pay the equivalent of 0.5% of the money stock for it. Now, though, that amounts to 15 shells. You are ecstatic because your asset has now appreciated in value to 15 shells. You now think the chief is omnipotent.

But your boat is only “worth” 15 shells because the quantity of shells has increased. If the quantity of shells (money) had stayed the same, at 1,000, your boat would still only be worth 5 shells. It’s not your boat that has increased in value; it is the value of a cowrie shell (the money) that has decreased in value. The chief has created a money illusion.

The chart below shows the Wilshire 5000 stock market index divided by the size of the Fed’s balance sheet, put into an index basis. Thus, it is showing the performance of the U.S. stock market relative to the Fed’s balance sheet. Or, in other words, it is showing what the U.S. stock market would look like without the massive monetary expansion by the Federal Reserve. Not only would the stock market be far, far below the high achieved in 2007, it would still be well below the pre-World War C (Covid pandemic) high of 2020.

This is the Fed’s money illusion. Disguising the true deflation of assets by inflating the money stock.