Six years ago, the Federal Reserve called the odds of deflation "extremely small" and assumed that it could easily curb such a threat. Bob Prechter said its assumptions were flawed -- and now those flaws become more visible by the day. See why Bob believes investors can’t be expected to respond rationally to banking changes in this excerpt of his January 2003 Elliott Wave Theorist:

Federal Reserve Chair Alan Greenspan recently asserted, “If deflation were to develop, options for an aggressive monetary policy response are available.” He gives no examples, presumably because he feels that Fed Governor Ben S. Bernanke said quite enough on that topic the previous month. Bernanke, now an economist at Princeton, agrees with the vast majority of economists and pundits that “the chance of significant deflation in the United States in the foreseeable future is extremely small.” He purports to explain, “The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand [for goods and services].” However, he makes no mention of why demand can collapse, either because it is a mystery or because he wants to avoid saying so.

The true source of deflation is system-wide bankruptcies induced by the contraction of a prior credit bubble. Without the preceding bubble, “demand” would never collapse...

Bernanke is a social mechanist. He thinks that if you pull one monetary lever on the left of the macroeconomic machine, the lever on the right will go down, too. Disinflation makes central bankers look smart, when, in fact, it is the natural trend of the psycho-monetary cycle and results from society-wide ignorance of macroeconomics.

Can you imagine the laughingstock that the Federal Reserve System would become if its “assets” consisted of defaulted mortgages, bonds of bankrupt companies and municipalities, IOUs of shaky foreign governments and stock certificates of companies no longer in existence? Can you imagine the panic that would ensue to escape a monetary system with such assets as its reserves? Bernanke’s primary problem is that the only object he thinks exists is the monetary ledger, an inanimate balance sheet. He does not consider the responses of actual people and markets to his proposed policy actions, which will result in unintended consequences…

The human mind is not a machine, and people are not easily predictable. Right now, investors are jacking up the risk of their holdings because interest rates on safe debt issues are low, moving out of the frying pan and into the fire. According to Fitch Ratings, nearly 50 percent of the $100 billion worth of “speculative grade” debt issued from 1997 through 1999 has already gone into default. Yet desperate investors, many of whom depend upon interest income to live, are buying more of the stuff and risking their shirts. Did the Fed intend that outcome when it jammed rates lower? Are low rates helping the debt situation and the deflation threat or making it worse?

- Excerpted from the January 16, 2003, Elliott Wave Theorist