The stock market has fallen to a 5-year low and everyone is tightening their belts, just as I predicted. This has led to a major contraction of available money in the system for businesses and consumers. Credit is shrinking and the economy is joining in the contraction. As a result, deflation has taken hold. Wholesale consumer prices fell for the first time since 1982 and the contraction could continue into next year.
Only now, 2-3 months after the Fed should have seen the risks of deflation, do they acknowledge that deflation should be a concern. The obvious risks of deflation could have been anticipated months ago despite the passing of the government bailout. I'm not sure why Bernake and company didn't begin to develop a plan to stave off deflationary pressures at that point. It may be too late to stop deflation at this point.
Deflation tends to feed upon itself. A credit provider does not want to give a consumer credit for a product that is going to be worth less a month from now than it is now. And a consumer doesn't want to buy a product that is going to be less a month from now than it is now. Therefore, consumers stop spending and credit begins to dry up. As credit dries up and consumers stop spending, the economy continues to contract. And a contracting economy leads to increased deflation.
The next two months will set the trend. If the Fed doesn't immediately cut interest rates again and start spending the bailout money and encourage additional lending, deflation will take hold and it will be a long 2009. January 20, 2009 is too far away. The matters are pressing now and won't wait that long. If Congress and the Fed sit on the sideline much longer, the damage will be irreversible. And long lasting.