inflation or deflation?

Frankly, I have been surprised by the number of questions we have been getting about the inflation risks associated with the various liquidity and stimulus plans coming from the Federal Reserve and Treasury Department. Am I concerned about inflation? Sort of. But, what I'm concerned about is the lack of inflation … or better put, my concern is more about deflation than inflation.

We're in a recession that, I believe, began a year ago. It's unlike any seen in the post-Depression era. Typically, recessions are caused by rising inflation, related aggressive Fed policy tightening and/or inventory cycles. This is a balance-sheet recession with deep roots in asset deflation and deleveraging, and is accompanied by careening global equity markets, falling commodity prices, stagnant wages and declining production. This is all disinflationary, if not deflationary.

the Fed's balance sheet has swelled massively, as you can see in the chart below.

Fed's balance sheet goes parabolic

Under normal circumstances, an increase in dollars would elevate inflation risks, but this environment is anything but normal. The global credit crisis is rapidly slowing the circulation of dollars, which will offset the effects of an increase in global money supply.

Even if reliquified, are banks going to jump to lend aggressively again? Not likely. Are households and businesses going to line up to the credit trough aggressively? Not likely.

The simple force of a decline in credit will not only limit economic growth, but inflation, too. Indeed, as I suggested in my recent report on deleveraging, "A Transformational Era of Deleveraging," the government will likely be stepping in as the spender of last resort, but as it represents a fraction of the weight in gross domestic product (GDP) relative to consumer spending, it's not likely to fuel inflation.

Yes, the growth rate in the monetary aggregates is accelerating, but this is neither a sufficient nor necessary condition for rising inflation. What also impacts inflation is the "money multiplier," or the ratio of M2 money supply to the monetary base. It shows whether the rise in bank reserves is spreading out into the broader economy. As you can see in the chart below, it has nose-dived recently and if it fails to accelerate after the normal lags, expect more action from the Fed.

History shows that during major periods of deleveraging, the "velocity" of money ebbs and acts as an offset to the rise in money supply. That's exactly what happened in Japan during the deleveraging era of the 1990s. The money supply remained confined to banks' balance sheets as demand for credit remained weak. When bank and household balance sheets are shrinking simultaneously, it's deflationary, not inflationary.

-- by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.