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The great sucking sound on Wall Street has few redeeming features, with the possible exception that it'll cleanse the economy of long-running financial excess and dampen, if not kill, the former inflation for a time.

Today's update on consumer prices for August offers a preview of things to come. The CPI dropped a seasonally adjusted 0.1% last month, the Bureau of Labor Statistics reported today. That's a sea change from the surges of 1.1% in June and 0.8% in July. The last monthly decline was -0.4% in September 2006.

That still leaves CPI higher by 5.4% in August from 12 months previous, but the annual pace of CPI is likely to fall further in the months ahead. The reason, of course, is that demand generally is retreating. From commodities to large-screen TVs to the three-bedroom ranch in the suburbs, the marginal growth in buying overall has evaporated.

One need only read the newspapers in the past 24 hours to understand why. Deflation, in short, is the big risk at the moment. It may or may not pass quickly, but that's the primary hazard hanging over the economy as we write. Rest assured that the Federal Reserve will continue to inject liquidity into the system as insurance to keep the blowback from Wall Street from infecting Main Street. The helicopters are surely in the air and Captain Ben is about to release the proverbial bags of money.

We have no problem with the central bank going to extraordinary lengths to keep the system from seizing. That's the only challenge today. The question is whether, and when the bank will commence a mopping up effort at the appropriate time down the road. Keep in mind that the government is accumulating lots of new debt as a result of the financial troubles. The recent bailout of Fannie Mae (FNM) and Freddie Mac (FRE), for instance, will increase government's red ink by a tidy $300 billion, estimates economist Nouriel Roubini in an interview via Advisor Perspectives. And it's not clear how much more the government will have to spend before the crisis is over. Meanwhile, the ongoing expenses of modern government continue to roll on, i.e., the expanding price tags for Medicare, Social Security, the Iraq War, and on and on.

The path of least resistance is still printing more money. For now, however, no one really cares, given the turmoil of the moment. And rightly so. Focusing on whether AIG (NYSE:AIG) will be liquidated, for instance, is the priority, as today's FOMC meeting will surely reflect. The long-term isn't dead, but it's taken a back seat to the events of the moment.

Nonetheless, for those who can still look out a year or more, inflation is still an issue, although the future of pricing pressure depends on what unfolds in the coming weeks and months. How bad will the economy be hurt? How steep will job losses be? How will foreign economies be affected? And on and on.

Monetary policy is fated to attack the virus du jour, which is a function of falling demand and the associated illness of deflation, either real or perceived. No wonder, then, that the stampede into Treasuries went up a few notches yesterday. And for good reason, since there are real and present deflation dangers afoot. The D risk may soon pass, and it may evade us entirely, but for the time being no one really knows and so the Fed will and must act on the side of assuming a rising D risk.

The Faustian bargain of central banking is on full display. Trading long-term price stability for short-term comfort is always lurking, although it's rarely on such a stark display as it is now. The good news is that enlightened policy can navigate the two quite well by satisfying the immediate needs of liquidity without throwing away price stability over time. The bad news: human error hasn't been banished.

Source: Inflation Concerns? That's So Yesterday