A lot of people have been discussing inflation recently. Deflation seems to get less attention but can be just as bad and just as likely.
Most economists consider inflation a purely monetary phenomenon. Most regular people nod in compliance, shuffle their feet and tend to agree. The truth is that inflation is both a monetary and goods supply & demand phenomenon.
Many commodities have limited substitutes and therefore experience extreme price swings as demand falls short of even limited supply. Oil is a good example with relatively little immediately replaceable substitutes.
The demand destruction in the oil market due to high prices is obvious from information from the DOT in the chart to the left provided by the New York Times.
For now lets just talk about flation, be it "in" or "de". The real problem with flation isn't where it is numerically, but rather how quickly it is getting there. The more rapidly flation changes the less efficient the economy is at providing goods and services. Flation either "in" or "de" in extremis is bad.
Economists as a rule of thumb like to see about 1-2% annual inflation. My own belief is that this allow govt's to quietly sneak out of their obligations (for those of you who speak French the pun is intended).
Pirate flation: Rum and hope.
Here is a simple model of flation based on a pirate economy. In this example we imagine one basket of consumable goods that pirates want. This basket is made up of Rum and Limes. Pirates don't like scurvy and Mojitos are a great preventative.
On our pirate ship circulate various forms of money, dollar bills and gift certificates. The gift certificates are promises of dollar bills in the future.
The money supply is simple, there are $100 in bills, $100 worth of certificates and perfect demand equating to $200 worth of goods.
Lets watch the flations and see what happens.
One of the more intelligent Pirates named Bob Banker" claims to have a bit of booty buried on a nearby Home island. His best friend,"Moody", chimes and says, "argh it be AAA sure thing tis treasure on that island me hearties."
Based on Bob Bankers claim and Moody's rating of Bob's claim, Bob writes IOU certificates for $100. The other pirates accept these as valid claims and swap rum and limes with Bob and Moody. There is now $300 chasing the same basket of goods. We have just met monetary inflation.
Pirate Pete the proud owner of a bottle of Rum, likes the story and trades his Rum for some of Bob's certificates at the new rate. He never questions the fact that Moody is a bit of a booze hound and may be getting a few sips for supporting Bob Banker's claims of treasure on Home island.
The price of rum and limes has just gone up this is monetary inflation.
At some point a Chinese junk pulls up next to the pirates offering a bottle of Lum (strikingly similar to Rum, but with an iffy label). The pirates trade one of Banker Bob's treasure claim certificates for the bottle of Lum and they have. The Chinese sail away with their treasure certificate and there are fewer treasure claim certificates on board the ship, but more Lum. Nothing changed from a flation perspective. Less money, more Rum all is balanced.
Pretty soon the pirates sail over to Banker Bob's treasure island. They lower Bob over the edge and into a skiff with trusted first mate Moody. Bob and Moody return with a sorry tale about subprime tidal waves and 100 year storms washing away the treasure chest on Home island.
Instantly a lot of angry pirates discover they have worthless paper certificates on their hands. Bob and Moody have drank some of the mojitos, leading to a minimal recovery. We now have monetary deflation, there is less "money" to chase around the same amount of Mojito supplies and everyone wakes up to realize Banker Bob and Moody will probably be walking the plank soon. First officer Fed who slept through the whole thing is put on duty to watch Banker Bob and Moody.
After the chaos that ensues in the deflationary environment, the price of Rum and Limes declines in which many pirates can't afford Mojitos due to a lack of "money" and may get Scurvy (health care crisis) everyone remembers to pull in the anchor and set sail, as the Chinese Junk is sure to return and they aren't going to like the treasure story.
The credit crunch has been seen an incredible destruction of "money". The size of the "loss" in paper value due to the disappearing treasure is only now being figured out. The destruction of "money" is happening quite rapidly. In the background is an increase in demand from various markets for raw commodities. Where the forces of deflation "money supply destruction" and "increased commodity" demand end up no one knows. The forces and volatility are huge and yes the Chinese are going to upset when their US Treasury paper and claims to green pieces of paper turn out to be less than solid.
Your gas may go up in price due to global demand while the amount of money in other forms declines. Inflation in terms of supply shortage combined with less available money to chase it is a strange paradox that might net out to a "neutral" flation but extreme consumer pain. Oil could get expensive while everything else "services" intangible assets etc. drops like a stone in price due to demand destruction, not a pretty picture.
One can't assume that the CPI which measures average economic "inflation" is in any way going to reflect the experience the US may be in for. Remember the great depression was a deflationary event.
