The pundits who insist on inflation coming before deflation do have a point: we have already had the inflation for the better part of the last two to three decades, and we have been battling the onset of deflation ever since the financial crisis broke out.

The popular belief that the 2000’s were a low inflation decade is a myth caused by the common conflation of inflation with the typical ways that governments track the Consumer Price Index. Inflation is the expansion of base money plus bank-created credit. (For background reading on why this is the correct definition of inflation, please see Fiat World Mathematical Model). The CPI is an index of an arbitrary basket of consumer prices with some arbitrary weights attached. Changes in the CPI are often correlated with inflation, but need not always be correlated. The degree of correlation depends on, inter alia, what is measured in the CPI and on the source of the external shock that changed the prices in the first place.

Take the US case, where most of the colossal credit expansion of the last decade (aka the inflation) went into the creation of a housing bubble. If we restate the official CPI to have it take into account changes in housing prices as measured by the respected Case-Schiller index, thus improving the inflation-CPI correlation, then we find that we had “inflation” way above the 1.5% to 2.0% official targets in the decade that ended with the recent financial crisis, and that we have been battling the onset of deflation ever since (see the red line in the chart below for the adjusted CPI and compare it with the blue official CPI line). As long as the private sector deleveraging continues, with the debilitating effect on asset values, inflation will not return.

Turning now to causes of changes in the CPI that are unrelated to money and credit inflation, let’s consider the example of oil prices. Since 2005, oil prices have been rising because of supply-side constraints. Rising oil and food costs showed up in the CPI as price increases, but household budgets, whose level of indebtedness had been rising for 20-30 years, could not afford these externally induced increases for food and gasoline and also continue to pay the high interest rates (in green above). The first ones to go under were the subprime borrowers, bringing the health of banks into question and starting the deleveraging / debt deflation cycle.

So, high oil prices combined with unbearable private debt burden produced first an increase in the CPI (not inflation) and then deflation via the induced balance sheet recession.