Look at the photo of a dollar below:

See where it says “Federal Reserve Note” and where it says “This note is legal tender…”?   Dollars are notes or debts, that is, obligations of the Federal Reserve.  When the Federal Reserve buys US Treasury Bonds from the open market  and pays for them with dollars (a process some refer to as “monetization” or “printing money”), it and the marketplace has simply exchanged one form of debt for another.  The supply in the hands of the market of one kind of debt (dollars) increased while another (Treasury Bonds) decreased.   Long before the Federal Reserve got involved to exchange dollars for Treasury Bonds – when the Treasury bonds were first created and sold to the public – that’s when the notional value (that is, the proceeds) of those Treasury Bonds was attached to goods and services.  Increases in government debt, as well as increases in private debt (net), are inflationary.  But not the monetization of the debt by the Federal Reserve.

At present, we have a situation where private debt is being reduced faster than government debt is being increased so that, in aggregate, total debts are declining – this is deflationary.

Technically, the total supply of debt can increase in an amount equal to the amount which society saves each year without inflation.  Conversely, total debt (including new equity shares) must increase by the amount of savings each year, or… we will have deflation.

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You don’t have to be a bank to inflate or deflate.

Jimmy Songwriter sitting at the bar has a flash of inspiration and quickly writes down a new song.  His somewhat inebriated friend, Joey Songsinger hears the song once and enthusiastically offers to buy it for a price equal to “whatever it takes – even if it’s the whole income of the United States”.   Jimmy Songwriter, as a joke and to teach his friend a lesson, tells Joey he will sell the song for $13 Trillion and that he would finance it and Joey signs a note to Jimmy for $13 Trillion.  This single transaction goes on record as the highest price ever paid for a song… drives up the average price of all songs by a factor of thousands…and doubles nominal GDP  and the average price of all goods and services in the United States.  The next year at Christmas, when the note comes due, Jimmy sends his friend Joey an email offering to “settle” the note for $500.  Joey gladly agrees.  After all they both knew that’s what the song was truly worth …and what Joey could pay.  That year, nominal GDP falls from the previously inflated level by roughly 50% with a 50% deflation in the price level as there are no more songs sold (and financed) for such exorbitant prices.

Notice:

1. We didn’t need banks or the Federal Reserve to create the price inflation or the price deflation which followed.  All we needed was debt creation and then the subsequent de-leveraging and return to “normalcy”.

2. Neither Jimmy nor Joey had the legal power to “print” or coin “money” and they did not need it to affect the price level.

3. Most importantly, what Jimmy and Joey do can offset and overwhelm whatever the Federal Reserve and the banks do.

Dave Rosenberg in his “Breakfast with Dave” for Thursday, May 20th points to the Shiller PE ratio:

In the past 130 years, whenever the Graham/Dodd/Shiller normalized P/E ratio goes above 20.6x (it is 21x today), the market experiences a significant correction – a correction of 31% on average over the next 16 months. It never fails.

It never fails… hmmm, 31% down on the S&P from here would put the S&P down to about 770.

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