Again yesterday, we saw our formula at work.

Inflation boosts up commodities, gold and oil; deflation takes its toll on stocks. The price of oil hit a new record high, while the Dow lost 214 points.

What is surprising is that stocks have not lost more.

As Richard Russell puts it:

“Everybody knows that this bloody market is supposed to go down. The dollar is sick, US deficits continue and they’re huge, consumers are pulling back on their spending, the housing picture is a disaster, the war in Iraq is God-awful expensive, the banks are wobbly and inflation is heating up.

“So why hasn’t the market already crashed?”

“Consumers are being squeezed from several directions,” Fed Governor Frederick Mishkin said in a speech this week. Reduced household wealth, combined with a weakening job market and near-record fuel prices “are likely to restrain spending growth in the period ahead.”

The report on Bloomberg continues: “Owners’ equity as a share of their total real-estate holdings fell to 47.9 percent, the lowest since quarterly records began in 1951, from 48.9 percent in the prior period.”

Foreclosures just hit a new record level, as owners “give up” trying to make mortgage payments on houses that aren’t worth what they owe on them. And now comes news that U.S. household net worth declined in the fourth quarter. With the loss of equity in their homes, Americans were down $532.4 billion.

While the little guy takes his lumps, so do the big fellows. Merrill (MER) had to shut down its subprime lending unit, reports TheStreet. Carlyle’s mortgage fund defaulted. Peloton investors won’t get a penny back of their investments, say the latest reports. And UBS (UBS), HSBC (HBC), Credit Suisse (CS), Societe Generale (SCGLY) – they’re all still toting up their losses.

“Deleveraging’s vicious spiral picks up speed,” says the Wall Street Journal.

Until now, investors have been mostly positive on the situation. They saw trouble coming but assumed it would be easy to deal with. They applauded the Fed’s quick response and believed it would soon put the economy back in the pink of health. Practically every prediction included a “recovery in the second half,” provision. Now, the commentators aren’t so sure.

Martin Barnes of the Bank Credit Analyst says, “The recovery is likely to be unusually shallow given the headwind of an extended deleveraging cycle.” Even the Kiplinger Letter sees a downturn that “may be short, just a quarter or two of negative growth. But recovery will take much longer with ill effects lingering till at least 2010. There’ll be no quick snapback in job growth, no strong surge in income, spending or profits.”

Standing against this grim prospect we have a thin blue line of feds. Cutting rates, providing tax refunds, urging the banks to forgive mortgages, and preparing a multi-billion dollar bailout – the feds are going to ‘do something.’ But what can they really do? Ah, there’s the rub. These cops have no shields, no truncheons, no hoses and no shotguns. How can they stop the mob from deleveraging itself?

We recall Paul Volcker’s words from last autumn. “The Fed has lost control of the situation,” he said. Like a line of policemen, trying to control a crowd, the Fed is pushed out of the way by events. Despite its rate cuts, the deleveraging continues.

But inflation continues too. And the more the feds fight the deleveraging process – with the only thing they have at hand, more paper money – the higher inflation rates go.

It is just a matter of time, says our old friend, Marc Faber, before the Fed will “destroy the U.S. dollar.” The United States is now in a “‘de-leveraging’ phase where banks make fewer loans, stunting economic growth,” he said, adding that he thought a U.S. recession began two or three months ago.

“In the U.S., they pursue essentially economic policies that target consumption, which in my opinion is misguided,” Faber said in an interview with Bloomberg Television from Chicago. “They should pursue economic policies that stimulate capital investment and capital formation.”

The Bloomberg report continues: “The Standard & Poor’s 500 Index is down 9.7 percent since Sept. 18, when the Fed began cutting the fed funds target to 3 percent from 5.25 percent. The dollar has lost 9.2 percent of its value versus the euro, crude oil futures gained more than 29 percent and gold added 34 percent during that time.

“Further interest-rate cuts may spur inflation and reduce the value of 10- and 30-year Treasuries, Faber said, calling the bonds “a disaster waiting to happen.” Ten-year notes fell to a four-year low of 3.44 on Jan. 22.

Marc went on to say some other interesting things, according to the report:

“Faber said sugar is inexpensive relative to other commodities and said stocks in emerging markets are more vulnerable than U.S. equities because speculation has created larger asset bubbles. He predicted shares in India and China could lose 30 to 40 percent of their value as markets decline worldwide.”

*** What happens to a paper currency when its custodians decide to destroy it? We have the answer to that question illustrated for us in the headlines from Zimbabwe. Last we heard, inflation was running at 100,000% per year. The average employee made millions per day but could barely buy a can of beans with the money. Worse still, the beans – and everything else – had disappeared from the shops; hyperinflation has destroyed the economy.

Yes, that’s what happens. First the money. Then, the economy. Finally, the society itself.

Today’s news tells us that the inflation rate has driven the Zimbabwe down to a new record. It takes 25 million of them to buy one U.S. dollar. At least there is one place on earth where the dollar is going up!

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.