Inflation, Deflation or Some Nasty Hybrid?

While we debate whether falling prices or rising prices would be worse, we could be in for a third scenario. The bright side: Investors might have a way out of the mess.

Inflation is a sexy worry.

We can photograph it. A photo of a billion-dollar bill next to a pile of apples from Zimbabwe's recent bout of runaway inflation stuns the imagination.

Causes of inflation and deflation

And we know what to do about it: raise interest rates, rein in the money supply or, if worse comes to worst, send the economy into a recession.

Deflation isn't sexy.

It's hard to photograph money getting more valuable, and falling prices aren't terribly dramatic.

Japan has been sunk in deflation for years, if not decades, without violence in the streets or even noticeable anguish. The period doesn't even have a catchy name.

And we don't know what to do about it. Increasing spending, running big deficits and subsidizing spending all work in theory, but they don't seem to have done much to solve Japan's persistent deflation problem.Msn.Video.createWidget('PlayerAd1Container', 'PlayerAd', 300, 213, {"configCsid": "MSNmoney", "configName": "player-money-articles-16x9", "player.vcq": "videoByUuids.aspx?uuids=9af6d252-c9b9-44ce-bb92-82f06cd996fa,7057f895-f38e-4ac4-851c-e8ea1bd8d977,39245e19-812b-2347-a276-7a9a8cdf30e7,4d08c146-37ff-4186-bdd4-91725ed1a955,9cc051b2-70e1-4d2e-ab56-87afde302587,ca675609-20f5-1f14-f55d-daeb6c228cbf,43e8fe02-ae62-4227-b85a-b9ed06ee51e8,ad2c47ea-3c4d-4fb1-9995-d9b38eb5bfc4,91260fda-1038-42c9-808d-917eeae9cc01,4fb189b3-db70-4249-82c3-5752083c3877,001bcf32-063c-421c-a0de-48d6eb94863c,9a38eced-add1-4954-ae30-54980569f5b6,1d4bc906-bf12-4f9e-b537-f2415697eeef", "player.fr": "iv2_en-us_money_article_16x9-Investing-JubaksJournal"}, 'PlayerAd1');Msn.Video.createWidget('Gallery4Container', 'Gallery', 304, 150, {"configCsid": "MSNmoney", "configName": "gallery-money-articles", "gallery.linkbackLocation": "bottom_left", "gallery.numColsGrid": "3", "gallery.categoryRequests": "videoByUuids.aspx?uuids=9af6d252-c9b9-44ce-bb92-82f06cd996fa,7057f895-f38e-4ac4-851c-e8ea1bd8d977,39245e19-812b-2347-a276-7a9a8cdf30e7,4d08c146-37ff-4186-bdd4-91725ed1a955,9cc051b2-70e1-4d2e-ab56-87afde302587,ca675609-20f5-1f14-f55d-daeb6c228cbf,43e8fe02-ae62-4227-b85a-b9ed06ee51e8,ad2c47ea-3c4d-4fb1-9995-d9b38eb5bfc4,91260fda-1038-42c9-808d-917eeae9cc01,4fb189b3-db70-4249-82c3-5752083c3877,001bcf32-063c-421c-a0de-48d6eb94863c,9a38eced-add1-4954-ae30-54980569f5b6,1d4bc906-bf12-4f9e-b537-f2415697eeef;videoByTag.aspx%3Ftag%3Dmoney_dispatch%26ns%3DMSNmoney_Gallery%26mk%3Dus%26vs%3D1;videoByTag.aspx%3Ftag%3Dbest%2520of%2520money%26ns%3DMSNmoney_Gallery%26mk%3Dus%26vs%3D1"}, 'Gallery4');About the best we can do is to use metaphors -- "fighting deflation is like pushing on a string" -- and pursue policies designed to keep inflation from establishing a beachhead.

That is why the possibility of deflation worries so many investors and economists right now. And why investors need to guard against both of these possibilities, as well as a third alternative that mixes some of the worst of both.

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What sliding house prices might portendIf you look, you can see what might be signs of deflation.

Certain big categories of prices are falling or have fallen and look likely to keep on falling. I'm talking about housing. Prices for this big-ticket item are still falling in the housing-boom-to-bust economies of the United States, Spain, Ireland and the United Kingdom. Economists predict that prices in some of these economies could keep on falling for five years. In the United Kingdom, for example, PricewaterhouseCoopers recently predicted that there was a 70% chance that the real cost of a house in 2015 would be below the price in 2007.

And you can certainly make the point from recent data that U.S. consumers are following in the footsteps of their predecessors in Japan in putting off purchases. That's a hallmark of deflationary psychology: Money will be worth more tomorrow, because prices are falling, so the inclination is to postpone spending as long as possible in order to take advantage of that.

The Federal Reserve reported July 8 that consumer credit -- the amount that consumers owe on credit cards and loans -- decreased at an annual rate of 4.5% in May. Revolving credit -- credit card debt -- decreased at an annual rate of 10.5%. That contributed to a 1.2% drop in consumer spending in the second quarter of 2010.

I think you can make a case for a rising danger of deflation. Nobel Prize-winning economist Paul Krugman made just such a case in his New York Times column on July 12.

But I also think you can make a case for a rising danger of inflation. Some very large economies -- China's and the United States', to mention just two -- have vastly increased their money supplies in the past year. Neither has seriously begun to reverse those increases. True, the Fed has stopped buying some classes of assets, but it certainly hasn't begun to sell those assets back to the financial markets.

And then you've got the traditional inflationary trappings of massive government budget deficits, often an inducement to governments to inflate their way out from under some debt.

Continued: 2 keys to the debateMore from MSN Money and MoneyShow.com

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Connect with JimBecome a fan on FacebookSubscribe to his e-mail newsletterDecision CentersStart InvestingMutual FundsFind Hot StocksSimple StrategiesPower ToolsInvesting for IncomeReal Estate InvestingRecent Articles by Jim JubakCan China keep its economy afloat? 07/12/2010Are stocks cheap? (And which ones?) 07/08/2010Which way(s) will world markets go? 07/01/2010More...Jim's Most Recent Top Stocks PostsJPMorgan earnings: Less than meets the eyeIntel moves up the value chainShanghai traders wait for real newsFund data provided by Morningstar, Inc. © 2009. All rights reserved.StockScouter data provided by Gradient Analytics, Inc.Quotes supplied by Interactive Data.MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.Msn.Video.createWidget('Gallery8Container', 'Gallery', 500, 230, {"configCsid": "MSNmoney", "configName": "gallery-money-article-site-wide"}, 'Gallery8');msft.msn._ic.cid='s6vtf58ncf9es0vuuk8mnk0nkgdc3ext';msft.msn._ic.pst=false;msft.msn._ic.pgn=1; Join the discussion!Add a commentShow commentsSort by:Newest firstOldest first_uc2f12('iucGo');1 - 3 of 3PreviousNextSteve 2535 #1Thursday, July 15, 2010 8:25:11 PMThe prices of some items at Burger king just keeps going up and up. No deflation there at all. Not everywhere is in a recession.  What a lot of fast food places are doing now is lowering prices on heavily advertised items and raising prices on unadvertised items to make up for the difference. Kind of a rob Peter to pay Paul kind of thing.ReplyReport Abuseanonymous888 #2Thursday, July 15, 2010 8:26:33 PMThe only way that America could experience DEFLATION is if China allows it as long as China buys US bonds, America will experience DEFLATION and China will experience INFLATION.  Which ultimately will lead to DEPRESSION for the World economy.  If China decided enough is enough and stops buying US Treasury Bonds then America will experience the worst Hyper Inflation in the history of the World, it all depends on China at this point in time. ReplyReport AbuseSteve 2535 #3Thursday, July 15, 2010 8:38:52 PM

Also I just bought a house (@4.50% 30 year fixed) and let me tell you they are now very strict on home loans. I had to show everything except my blood type to get a loan. But I don't mind as I passed the test with flying colors.

This is what should have been done all along. If it was, you would not have the economic mess you have now. There were people getting $500,000 loans for a house when they could not even afford a dog house. No wonder everything crashed.

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That is why the possibility of deflation worries so many investors and economists right now. And why investors need to guard against both of these possibilities, as well as a third alternative that mixes some of the worst of both.

What sliding house prices might portendIf you look, you can see what might be signs of deflation.

Certain big categories of prices are falling or have fallen and look likely to keep on falling. I'm talking about housing. Prices for this big-ticket item are still falling in the housing-boom-to-bust economies of the United States, Spain, Ireland and the United Kingdom. Economists predict that prices in some of these economies could keep on falling for five years. In the United Kingdom, for example, PricewaterhouseCoopers recently predicted that there was a 70% chance that the real cost of a house in 2015 would be below the price in 2007.

And you can certainly make the point from recent data that U.S. consumers are following in the footsteps of their predecessors in Japan in putting off purchases. That's a hallmark of deflationary psychology: Money will be worth more tomorrow, because prices are falling, so the inclination is to postpone spending as long as possible in order to take advantage of that.

The Federal Reserve reported July 8 that consumer credit -- the amount that consumers owe on credit cards and loans -- decreased at an annual rate of 4.5% in May. Revolving credit -- credit card debt -- decreased at an annual rate of 10.5%. That contributed to a 1.2% drop in consumer spending in the second quarter of 2010.

I think you can make a case for a rising danger of deflation. Nobel Prize-winning economist Paul Krugman made just such a case in his New York Times column on July 12.

But I also think you can make a case for a rising danger of inflation. Some very large economies -- China's and the United States', to mention just two -- have vastly increased their money supplies in the past year. Neither has seriously begun to reverse those increases. True, the Fed has stopped buying some classes of assets, but it certainly hasn't begun to sell those assets back to the financial markets.

And then you've got the traditional inflationary trappings of massive government budget deficits, often an inducement to governments to inflate their way out from under some debt.

Continued: 2 keys to the debateMore from MSN Money and MoneyShow.com

 1 | 2 | next >

Check out Jim's top stocks for the next 12 months.

Read how to invest with Jubak's showcase portfolio.

Follow the long-term portfolio from Jim's book "The Jubak Picks."

See Jim's new portfolio to help navigate the treacherous interest-rate environment.

Also I just bought a house (@4.50% 30 year fixed) and let me tell you they are now very strict on home loans. I had to show everything except my blood type to get a loan. But I don't mind as I passed the test with flying colors.

This is what should have been done all along. If it was, you would not have the economic mess you have now. There were people getting $500,000 loans for a house when they could not even afford a dog house. No wonder everything crashed.

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