How Investors Can Play the Reflation Trade

Jeff Kleintop TheStreet September 29, 2010

NEW YORK (TheStreet) -- Last week, the official recession-dating committee, the National Bureau of Economic Research, announced that the recession was officially over in June of 2009. This was not surprising to most market participants.

In a surprisingly transparent statement made last week, the Fed told us that inflation is so low it is not doing enough to promote growth. Specifically, the Fed's stated: "Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability." The Fed balances employment and prices by seeking growth that generates the highest level of employment without causing too much price inflation. The Fed has spent much of the past 30 years determining when to attempt to slow down an economy that is growing too rapidly in order to avoid the destructive effects of high inflation. However, when inflation gets too low, as the Fed has noted, it is a sign that growth needs a boost. The Fed typically acts as a counterweight to Congress' inflationary spending impulses. But the Fed has communicated its view that inflation is too low. With Congress unlikely to pass another substantial spending package, the Fed is likely to take action. Deflation Defined If inflation is a bad thing, then how can inflation be too low? Inflation results when too much money is chasing too few goods and services. This results in higher prices and usually happens when demand is strong but output is constrained in the form of shortages of materials or capacity. Deflation, or falling prices, is the opposite of inflation and generally occurs when the supply of goods rises faster than the supply of money. The problem with deflation is that when prices fall as output exceeds demand it can become self-perpetuating as consumers and businesses postpone spending because they believe prices will fall further. Consumers and businesses delay buying expensive items like homes or cars because they believe these things will be cheaper in the future. As a result, spending and economic growth slows. But it does not stop there. 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