In his latest post titled Myths about what is economically relevant, Mike Shedlock (Mish) once again explains his own definitions of inflation and deflation and also touches on how deflation can be consistent with rising food prices. I want to expand on the latter:

Given the ballooning expansion of fiat money and fractional reserve lending over the last few decades, by now money created as credit by commercial banks dwarfs the base money created by central banks. This leads to two important conclusions:

First, any study of monetary phenomena to assess inflationary or deflationary forces, which ignores net changes in credit creation would probably be hopelessly wrong.

Second, over a time scale of centuries and millennia, state treasuries and banks have progressively lost their power to inflate at will when the demand and supply for private debt collapse in a balance sheet recession, compared to earlier eras before the great expansion of “money as credit”. The modern tool of setting a baseline interest rate to stimulate or cool down the creation of new credit is useless in periods of deleveraging when banks and borrowers mostly want to retire existing loans. This is why the economist Joseph Stiglitz has labelled the Federal Reserve’s efforts with the ZIRP (zero interest rate policy) as akin to “pushing on a string“.

For better or worse, therefore, the expansion and contraction of bank created private credit is now the dominant force that determines aggregate demand levels across the economy.

Hence the definitions of inflation and deflation that Mish uses: inflation is an expansion of base money plus credit marked to market, and deflation is the opposite.

So, with collapsing credit far outweighing base money growth even after quantitative easing, the net direction of “money plus net new credit” is downwards. Some sector of products, services or assets must therefore fall in price as much of the aggregate demand for it suddenly vaporises into thin air. If one sector holds its price level or even appreciates thus increasing its share of the shrinking aggregate demand, then other sectors must deflate even more to compensate. Thus, strong demand for oil from the BRIC countries supports the price level of oil despite OECD softness in demand for oil. Oil is a tradable commodity with no short-term substitutes and food is a tradable commodity hugely affected by the cost of oil. With the food and energy price levels immune to the deflationary pressure of the net credit contraction, the brunt falls on sectors such as durables and investment assets, particularly speculative leveraged investment assets.

From the narrow perspective of the OECD, therefore, exogenously expensive oil which in turn raises the cost of producing, distributing or importing food, causes the assets, products and services that were deflating (most likely non tradables and discretionary sectors) to take a double whammy: not only the negative change in net credit creation, but also the shrinking share of aggregate demand that remains for these sectors after the new “oil tax” in food and energy (where demand is inelastic in the short term) is paid for. Thus, food prices can rise during deflation, which also aggravates the deflationary impact felt by the deflating sectors.


5 October 2010: After writing this post, I came across a pre-crisis article from June 2006, by blogger Charles Hugh Smith titled Could We Have Both Deflation and Inflation at the Same Time? where he makes exactly the same point about the wall of money having inflated non-tradeables, while globalization – tapping the low salaries of foreign workers – has kept down the cost of tradeable goods. Eventual mean reversion implies that assets can deflate and tradeables can inflate at the same time. The first part is already happening, and as for the second part, the deliberately engineered inflation within China plus supply-side limits in energy will eventually show up in the cost of tradeables as well.