Big banks don’t trust each other in the post-Bear Stearns market, and lending across the financial system is drying up.

This tighter credit environment is hitting money supply. Last month, money supply actually shrank – it grew at under the rate of inflation.

Charles Delvalle at Investor’s Daily Edge says this means investors should now expect deflation to hit asset prices.

This echoes Bill Bonner’s recent warnings about the risks of a coming deflationary slump in the U.S…

This from Charles…

Over the past few years our money supply grew at a double-digit pace. Money supply growth is, according to Austrian economics, inflationary since it is essentially more money chasing the same amount of goods.

But was the Fed sitting in some dusty room, turning the printing press just to flood the market with money? Not really. The Fed doesn’t actually print money. What they do is encourage banks to lend or not lend.

Sometimes they add temporary cash into the market by the use of short-term loans. Other times they increase the money supply by lending the government more money. But the biggest way they control the price of money is by adjusting interest rates to stimulate or discourage lending.

Earlier this decade, the Fed encouraged lending by dropping interest rates to dastardly low levels. This spurred banks and lending institutions to drop their interest rates to encourage borrowing.

But the Fed isn’t this all powerful institution. Sometimes what the Fed wants is very different from what lending institutions want. And what happened this past year is a perfect example of that.

Since August of last year, the Fed has dropped their target rate by 2.25 percent. And while prime rates (the rate banks charge their best customers) went down to reflect that Fed adjustment, mortgage rates and credit card rates (at least with my credit card companies) barely budged. Even highly rated corporate bond rates soared.

So even with a lower Fed target rate, it’s actually more expensive for a corporation to borrow money than it was when the Fed tried to discourage lending with the target rate at 5.25 percent.

Sounds crazy, right? Why would banks not lower their interest rates if the Fed is basically begging them to do that?

Because banks are losing way too much money. They need to protect themselves. And since they are in a riskier lending environment, it would make sense that they charge more in interest to make up for that risk.

So why am I talking about all of this? Because this lack of credit is starting to hit the money supply.

Last month, the money supply grew under the rate of inflation. In real terms, that means the money supply SHRANK. And let me tell you, inflation doesn’t last too long when the money supply is shrinking.

What we’re getting ready to see is not inflation at all… but deflation.

Now honestly, I came to this conclusion very recently. I’ve been one of the most adamant about the need to tighten up money. But as it turns out, the Fed didn’t have to tighten the spigot; banks did it by themselves.

And while I’m not saying that inflation will go away, what I am saying is that inflation should – so long as the money supply continues to grow under the rate of price inflation – definitely take a step back.

We already see this deflation hitting commodities, some of which have dropped 50 percent from their peak. We also see it in housing, which in some areas have seen drops of as much as 50 percent from the peak. And now, we’re going to start seeing it spread a little more and more over the entire economy.

Will consumer electronics become cheaper? Or maybe big ticket items like refrigerators and washing machines? It’s tough to say. My best guess is that anything that sold well during the housing boom will now see sales slow. As sales slow and inventory grows, prices will be slashed and the general vibe of deflation will take over.

Like I said before, inflation isn’t going away. It isn’t dead by any means. But the effects of deflation will soon begin taking the bite out of inflation and should help bring it back down over the next year.

This whole thing about deflation was something that Robert Prechter Jr. called in his book Conquer the Crash. Robert is very big into Elliot Wave Theory (the theory that markets move in cycles along with the social mood). According to his analysis, this credit boom was set to implode right about now. And the unwinding might last until the next decade.

In the end, the thing you have to realize is that deflation is a phenomenon in the money supply that will affect prices sooner or later. There is no dispute that in real terms, the money supply of the US is flat and moving lower. That, dear reader is the very essence of deflation.

Some may try and come back to me and say “Are you off your freakin’ rocker you long-haired scumbag?! The Fed is printing money through its Term Auction Facilities!”

Not so. Money supply has steadily dropped this year, despite those lending programs. The Fed is just trying to keep the system from completely locking up, not inflating the money supply.

Others might say that international growth should prop up the global economy, keeping deflation from taking hold. Well, where would China be if demand in the US and Europe both drop? Plus, last time I checked China was readying an economic stimulus package. Now, ask yourself this: Why would they need an economic stimulus package if their economy were humming along?

The only thing that will help prevent this episode of deflation from getting worse is if banks decide to start lending.

Source:  A Shocking Development in the World of Money