You figured it out
-- the scale can't differentiate between fat and muscle. If you lose 5# of fat and gain 5# of muscle, the scale will stay the same. But you'll lose inches because muscle is smaller and denser than fat (check out this picture:
http://www.3fatchicks.com/forum/atta...chmentid=17582 )
Two people can have the same scale weight with very different body compositions -- that is, the percent of their body that is fat and the percent that is lean body mass (LBM). Your body fat % is a better indication of overall health and fitness than the number on the scale. And that's why you'll see someone like MrsJim (Karen) who weighs around 150 but wears size 4 -- she's mostly muscle with not a lot of body fat. Very cool.
Hope that helps!