Everything on the monetary side points to more inflation in the future. Nevertheless, over the last half a year—especially since the “Credit Crunch� has gained strong momentum—deflationists have been emboldened to proclaim yet again that the economy will spin into a dreadful deflation, dragging everything in sight with it. I can understand the deflationist warnings, as I was once a deflationist, schooled by Robert Prechter, the Dean of the Deflationist School. His book Conquer the Crashis the ultimate reference book on deflations, The Deflationist Bible. Whether one believes in a coming deflationary depression or not, one must nevertheless read the book and understand its arguments.

The quintessence of Prechter’s book is that inflationary booms cannot last forever; here Austrians will eagerly agree. However, Prechter argues that inflation cannot last forever and that deflationary forces will overwhelm the financial system, so that the economy will tailspin into deflation; here Austrians will disagree, as they admit to the possibility of an inflationary bust, i.e., a stagflation.

Prechter provides (in Chapter 13, p. 130) three limits to credit expansion that we can actually observe. With these, we can determine whether monetary inflation can continue or not. His first limit on credit expansion is the rising price of gold; the second is the falling dollar, and the third is rising interest rates (due to rising inflationary expectations) and corresponding falling bond prices, which in itself is strongly deflationary. In Prechter’s terms, the three countervailing forces to inflation come from the gold market, the bond market, and the currency market.

Over the last six years, I have found these criteria to be extremely helpful, especially in determining whether the environment would turn deflationary any time soon. It is easy to analyze each and see if any currently represents a genuine limit to credit expansion.

1. Price of Gold:The price of gold has been steadily rising for the last seven years and it has not yet deterred the Fed from inflating. Clearly, whether gold rises to $1,000 or $2,000 or more, the Fed will remain unmoved by its rise. Also, just because the price of gold has been correcting for the last 3-4 months does not mean that deflation is here. An intermediate correction does not make a secular trend!
   

1. Dollar.Moving to the second limitation, apparently the Fed pays only lip service to the government’s Strong Dollar Policy. In reality, the Fed seems to like the idea of a falling dollar, as long as the fall is orderly. The Fed would most likely be pleased to see the dollar a lot weaker in the future, provided again that the devaluation is “orderly�.
2. Interest Rates.This third limitation is no limitation at all to an Inflationist Fed hell-bent on preventing deflation. The Fed has devised a number of ingenious approaches to support the long bond and has even stated in public that, if necessary, it will monetize the long end of the curve to support high bond prices and respectively low bond yields.

The deflationist arguments resting on gold, the dollar, and the long-bond yield apparently present no problems for the Fed at all. In reality, the Fed can inflate at will, and this is exactly what it’s doing!
At this point, there appears one, and only one, limitation that will force the Fed to slow down its monetary inflation and compel it to raise interest rates – a Dollar Crisis associated with a flight out of dollars and a panic in the currency markets, triggering a colossal currency derivative crisis.

Nothing short of this will constrain monetary inflation. At this point, it is my opinion that so long as the dollar devalues in an orderly manner, or the dollar actually rises against other fiat currencies, the environment will remain strongly inflationary.

Other deflationists have raised a very powerful argument in their favor. Typically during an asset deflation, where the prices of stocks and real estate fall, there are no willing lenders and no willing borrowers, no matter how low the Fed lowers interest rates. This is dreaded condition is known as “pushing on a string�. The classic example is Japan since 1990.

The counterargument is straightforward: in modern fiat monetary systems: the Central Bank is always a willing lender of last resort and the Government is always a willing borrower of last resort. In order to prevent contraction of credit, the government can always borrow and the Fed can always monetize – credit contraction and deflation do not have to occur when the Fed and the government do not allow it to happen.

So far, it is more than obvious that the Credit Crisis has not prevented the Fed from its inflationary course, despite the rhetoric to the contrary. In reality, the Credit Crunch combined with a contrived deflation scare and a rising dollar has provided a cover for the U.S. government to increase its budget deficits and an excuse for the Fed to inflate further. All monetary indicators confirm that the Fed has been successful in this regard