John Hussman’s comment this week is a must read, on inflation and the Fed.

“The proper model that ought to be in people’s heads is that, yes, the economy will probably slow down, but largely because it’s living on a mountain of debt that’s going to have a hard time growing because of a) stalling home values and b) a massive current account deficit that’s unlikely to expand indefinitely. So sure, the economy will probably continue to slow. If that happens, we can expect to observe higher, not lower, rates of inflation unless credit defaults increase enough to lower monetary velocity and counter the otherwise detrimental upward pressure that slower economic growth generally has on inflation.”

(Emphasis mine).

I agree 100%. So short-term, anyway, it will be inflation because there is not enough pain in the housing market yet to cause a significant level of defaults - and there probably won’t be until next year. I do believe it is likely that the level of defaults and associated damage to the financial system will cause deflation in the end. But that is just an opinion, by no means a foregone conclusion that one should use as the basis of any strategy at this point.

It is probably worth commenting that John is referring to the basic money supply equation, pq=mv. p (General Price Level) q (Quantity of Goods and Services) = m (Money Supply) v (Velocity of Money). In essence, the money volume of the economy (price x quantity) equals the amount of money available times the number of times each dollar is re-used - participates in a transaction - in a year. When credit is tight, money velocity is reduced, which means the left hand side of the equation must shrink accordingly.