Mike Shedlock, in his consistently thoughtful and informative blog, provides an excellent summary of the box canyon in which the Fed finds itself. In a post titled, Billmon Gets it - Do You?, he writes:

One of the reasons for these repetitive bubbles is the Fed does not itself know what inflation is. They think they can micromanage the economy when all they are doing is chasing their tale due to the lagging effect of their actions.

At some point, and I think we are at that point right now, a sort of economic zugzwang [chess term] is reached. I spoke about this in Red Queen Race...

In economic terms, there is no magic mirror. Bernanke is trapped in "Wonderland" but unlike Alice has no way out. Bernanke gets to choose between hyperinflation and deflation. The moment he can not run fast enough, the US economy will implode. If he runs too fast, the value of the US dollar as well as the Fed's power will both come to a very abrupt stop. In effect Bernanke is in Zugzwang and he does not even know it.

Eventually Bernanke (like the Bank of Japan) will have to choose deflation. The reason is simple: hyperinflation will end the game, which in turn would eliminate the wealth of the Fed as well as all of their power.

I mostly agree with Shedlock's analysis of where we are and how we got here. I also recommend his article, Inflation: What the heck is it? for an Austrian-minded view of the credit cycle and inflation.

I agree with Shedlock that the Fed will at some point face a choice between deflation and hyperinflation. I will give a short outline of why this is the case, and then suggest some reasons for choosing the inflation card.

Inflation is the expansion of money in a fractional reserve banking system. The inflationary effects on prices of monetary expansion have long been understood. The Austrian economist von Mises developed a theory of the boom and bust cycle based on bank credit expansion. His an analysis showed that inflation not only affects prices in general, but also distorts relative prices between capital goods and consumption goods. This leads to an over-allocation of productive investment into more credit-sensitive parts of the economy, which is reflected in financial markets through increases in financial asset prices. The stock market bubble of the 90s was an example of this, as was the subsequent housing bubble.

Markets are always trying to bring prices back to equilibrium. Under the influence of market forces, investments that were artifacts of an inflationary boom are eventually liquidated in bankruptcy. It is the adjustment of relative prices that brings the economy back to a sustainable balance of borrowing and saving. However, this adjustment process tends to be deflationary. The deflation occurs because, as the artificial forms of life created during the credit expansion phase of the cycle fail and default on their debts. When credit is defaulted, bank credit money is destroyed and there is a contraction of the money supply.

The corrective liquidation process can be postponed for some time through the instigation of another bout of inflation. This has been the Fed's strategy since the mid-80s. When in doubt, print more money. (See Antony Müller's Mr. Bailout for an excellent short history). After the collapse of the stock market bubble, the Fed's Brobdignagian inflation campaign has succeeded in creating a housing bubble, and now a commodities bubble.

But the ability of a central bank to reinflate is not without limit. The central bank must eventually face a final choice between hyperinflation and deflation for several reasons.

One reason is that each inflation cycle starts from a position in which the distortions of the previous cycle have not been fully liquidated. The economy becomes more fragile and less able to digest the next round of money printing. But the ultimate check on the central bank's ability to inflate is hyperinflation.

While the expansion of the supply of money and credit can lead to rising prices, and a high rate of credit expansion will produce a high rate of price inflation, there is no specific rate of expansion that will necessarily result in hyperinflation. Hyperinflation originates in the money demand side, not the money supply side. When the population comes to the en masse realization that the central bank has no intention of ever abandoning its policy of continued inflation, they begin to reject the existing fiat currency a medium of exchange.

Panic selling ensues, as anything that can still be bought for money is bid up in price as people frantically attempt to get rid of all their money while it still has some value. As money demand approaches zero, prices rapidly multiply then explode. For example, the current hyperinflation in Zimbabwe has driven the price of a single roll of toilet paper up to a reported $145,750 Zimbabwe.

When does the central bank face this limit? When the reinflation no longer works to maintain the artificial forms of life that were created during the boom. This limit is reached because, while the central bank can print money, they can't control exactly where it goes.

The inflationary nature of the credit-driven boom is hidden from most people as long as the prevalence of easy credit does not translate into rising prices of consumption goods. If for example, assets that make people feel wealthier - stocks and houses -- are going up in price, it will not be perceived as a process of monetary debasement. However, if the monetary injection escapes the confines of asset prices its true inflationary nature becomes more clear to the general population.

If the prices of goods that people buy every day noticeably increase, then the risk of hyperinflation looms. This process can feed on itself as people begin to sense the their money is worth less and less. There comes a point where more money expansion will not go into the artificial assets that were created by the earlier rounds, but feed into an acceleration in the increase in the prices of ordinary goods. This is the point where the central bank must choose between deflation and hyperinflation. If they do not stop the inflation at this point, the credit expansion will no increasingly run up the prices of goods and a rapid destruction of the money will result.

Mises described this point of no return in an oft-quoted passage:

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

When a central bank reaches this point, and they are unwilling to allow a deflation to occur, then it must inflate ever more rapidly. The ability of a central bank to inflate by lowering the discount rate and encouraging borrowing may be limited. However, their ability to create money is not. The coming hyperinflation will not be accomplished through credit creation. It will be through the direct monetization of financial assets, that is, the Fed will purchases asset with freshly printed money in order to prevent the asset prices from adjusting in relation to goods prices.

In the case where financial assets have been the prime beneficiaries of previous bouts of inflation, the central bank must be willing to buy up the assets of banks and other leveraged financial entities. As the bond market begins to perceive inflation, nominal interest rates will rice, putting downward pressure on bonds, and then in turn, on all credit-sensitive assets.

The adjustments in relative prices between asset prices and goods prices that are necessary in order to bring the economy back into balance will be achieved by goods prices inflating faster than asset prices. Asset prices will deflate in relative terms only.

Must Bernanke choose deflation over inflation, as Shedlock says? Shedlock is correct in saying that hyperinflation would destroy the dollar and likely the Fed's credibility as well. Indeed, this would argue against hyper-inflation. But here are some thoughts on why this reason alone may not be enough, and why we will probably end up with hyperinflation:

1. If the Fed chooses deflation over inflation, that would also destroy its credibility. A central bank is supposed to prevent both inflation and deflation. Milton Friedman blames the Great Depression primarily on the Fed for not inflating enough. This view is widely accepted among economists (except Austrians). Bernanke wholly subscribes to this view, to the point of literally apologizing on behalf of all central bankers for the Fed having allowing deflation before he was born. He has even promised as a central banker in good standing never to let it happen again. Who would doubt that the Fed would again be blamed by a generation of inflationist economists if it allowed the credit system to suffer a deflationary collapse?

2. While a hyperinflation would destroy the banking system, so would a massive deflation. The US banking system now has 60-80% of its assets invested in housing through the direct ownership of mortgages, as well as indirect ownership through mortgage-backed securities. A severe deflation would wipe out all of the equity in the banking system. To therefore conclude that the Fed would choose deflation to save the banking system is a fallacy.

3. There might be some constituency for deflation, other than the Fed itself (if you buy Shedlock's view of the Fed). But I can't think of what it would be. On the other hand, there is also political pressure from the entities that would be most harmed from a deflation, most importantly, the financial entities who survive on debt and leverage.

4. The Fed cannot reliably predict the point at which the next inflation is their last one. No button lights up on the central bankers economic control panel telling them exactly when they are on their last bubble. Even if Bernanke were worried about a bit too much inflation, it is likely that he would attempt to postpone the inevitable crisis with one more dose of inflation. After all, central banks subsist on the conceit that they can manage the economy.

5. As Hoppe argues in his book Democracy: The God that Failed, the democratic political system acts on a short time horizon. A crisis postponed is a crisis that someone else will have to deal with, after the next election. A short time horizon generates a built-in bias toward inflation. While a deflation would bring cleanse the system of waste and maladjustment, it would require a degree of pain and forbearance, a virtue in short supply in a democracy.

6. Under a democratic regime, there is always a demand for the authorities to "do something" to prevent a crisis. If a deflation were allowed to begin, then as banks began to fail, would there not be a great outcry for the crisis managers at the Fed to come up with some kind of a "plan to save the world", as they have done so many times? What could this plan be, other than some kind of buyout of bank assets? Recall the Long Term Capital Management crisis. A large hedge fund with loans from most of the major Wall Street banks was bailed out rather than allowed to fail.

7. Bernanke has a staunch ideological inclination toward inflation. I have written on this topic before in my piece on Bernankeism. Examination of a number of speeches and academic papers by Bernanke and his cohorts at the Fed reveals a number of crackpot anti-deflation schemes based on the monetization of financial assets. These schemes are at minimum being studied by Fed researchers, and perhaps being prepared for implementation. Their writings and speeches all suggest that, the deflation card is already off the table.

Are these factors decisive? Perhaps not. No one can say for sure what will happen. But I certainly won't be placing any bets against Bernanke and his fleet of helicopters.