Will Prices Rise or Fall?

Over the last two years the Federal Reserve and other central banks have taken extraordinary steps to provide cash (or liquidity, or reserves) to banks and other institutions. As the economy recovers and the new money makes its way into the hands of spenders, prices may be expected to rise.

However, anybody who has used a credit card knows that cash and credit are equivalent for a purchase; it is not just the amount of cash in the economy but the total amount of money and credit available that is relevant for the overall level of prices. So if credit shrinks, prices could decrease.

That is exactly what appears to be happening: for about a year now, total consumer credit has been shrinking (the latest Fed preliminary reading shows it falling at 5.75% per year.) This reversal of a decades-long trend is already pushing prices downward, as the recent trend in the Consumer Price Index seems to indicate.

The Fed creates cash and the banks create credit, so if credit creation continues to sputter, the Fed will find itself 'pushing on a string', and might be unable to reverse a serious credit contraction and resulting deflation of prices, notwithstanding Fed Chairman Bernanke's well-known determination not to let it happen.