Poor Ben Bernanke. The man is running from pillar to post - from Stamford Bridge to Hastings, fighting Vikings first, and then Normans...inflation here, and deflation there. Yes, he is fighting on two fronts.

Publicly, his big battle is with inflation. Rates went up another quarter of a point a week ago...for the 18th time in a row. And now, the papers are telling us that he'll take another swing at inflation next month. And we believe it, but for completely perverse reasons, which we'll explain.

"By August, the Fed will be thinking about lowering rates," says old-timer, Richard Russell.

Russell is usually right. And we admit to a certain amount of confusion here at The Daily Reckoning. But what war is Bernanke really fighting - against inflation or against deflation? Which is the bigger threat?

Looking carefully at a chart of bond yields, we come to the conclusion that the great bull market in bonds is over. It ended three years ago. What this means to us is that credit is becoming more expensive, not cheaper. And if we're right, this trend cannot be stopped by pulling levers and turning knobs at the central bank. Too many people are too far in debt. They need to pay down their debt, write it off, and work it out. That's what must happen before a new round of credit inflation can begin. But that process can take years. A whole generation of big spendthrifts has to learn an important lesson: that spending money won't make you rich. It's not a lesson that is learned the easy way, or overnight. In fact, it would be surprising if it didn't take a decade or more. In the meantime, you can expect a lot of grumbling.

Everybody likes a credit boom. They all believe they have more money. This is the dirty little secret of modern central banking. It only works by stealth and fraud - silently debauching the currency so that people make mistakes. The businessman believes there is more demand for his products than there really is. The consumer believes he has more purchasing power than he really has. The lender believes the borrower is a better risk than he really is. All these mistaken judgments lead to spending, investing and lending - which look at all the world like a bona-fide boom.

But it is an ersatz boom, a public spectacle, founded on fraud, expanded into farce, and ending ultimately in disaster. Eventually, everyone gets too stretched out on credit. Then, the bubble finally finds a pin somewhere, and the air wheezes out. That's the part that no one cares for, because, it is when people discover that they've made mistakes, that they've over-reached, and that they've been had.

If, as we believe, we're at the beginning of the disaster stage, the Fed's real enemy is not inflation at all; it's deflation. Typically, a credit contraction shrinks everything down with it. Earnings go down. Consumer spending is reduced. GDP growth falls...or even goes negative. And prices for most financial assets dive.

Both Bernanke and Greenspan recognized the deflation enemy, and raised rates - not to fight inflation (although that is what they appeared to be doing), but to "reload the gun." They had to hike rates in order to be able to cut them to fight deflation. Now, with 525 basis points from here to zero, at least the Fed has a new round of ammunition.

But what will get them to pull the trigger? The most likely signal of deflation is a slowdown in consumer spending. Since consumer incomes are either flat or falling, consumer spending depends on the real estate market continuing fat and flourishing. And for that, the housing market must be propped up like a corpse at a viewing. The Fed must try to keep house prices from collapsing - at any cost! But, the housing market depends on long rates, not short rates. Mortgages are long-term debt. And long-term lending rates depend largely on lenders' views on inflation. If they think they have a real inflation fighter at the Fed, they are most likely to lend at low rates. If, on the other hand, they see the Fed's knees weakening, or its hands toiling over a white flag, they're likely to want higher rates.

This explains why the Fed is still raising rates, even though it sees deflation as the biggest threat. It explains why Ben Bernanke may raise rates again in August, even though it is deflation he really fears. He is merely trying to keep mortgage rates low so the real estate market won't fall apart.

Now we see the Bank of Bernanke's strategy more clearly: it must crush inflationary expectations, while preparing to fight deflation as soon as it appears. When U.S. asset prices crack - that is, when stocks, bonds, and real estate begin to collapse - you will see another rush to cut rates.

It worked so well last time, from 2001-2004, it surprised us. Too bad it's not the sort of trick you can pull over and over.

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