Should Investor worry about Inflation or Deflation?

What’s going on with our economy? First, we have to acknowledge that we are in a secular bear market. We may be here a long time. Are we starting disinflationary spiral, a growth phase or approaching that dreaded inflation scenario? It depends; it seems, to a large degree, on your time frame and how you read the signals.

Deflation is a drop in prices. Products, services and commodities get cheaper. The Consumer Price Index (CPI) is most commonly used to gauge this. It is a non-seasonally adjusted inflation rate index. According to this weeks’ Barron’s magazine, the CPI was observed to fall for the first time year over year since 1955. In March, it fell 0.4% over the previous year. In our times, the stock market has suffered three large declines, the last 1937-38, due to deflation. But the degree of deflation was significant. We really have not experienced severe deflation since then. However, the best places to be are in long term government bonds and zero coupon bonds in a bear market with an excessive deflation. A small degree of disinflation can do wonders for the stock market though. Great bull markets have occurred under such a scenario. If so, we want to be in stocks. Are we starting an era of low deflation and a new bull in stocks? Right now we are in a deflationary setting. The stock markets have rallied in the last few weeks. Are we seeing growth or the beginning of the end of the recession?

More worrisome to most investors is inflation. Most people are more aware of inflation than deflation. Hyperinflation is a major worry. The question is not so much if as when? Right now, the Economic Cycle Research Institute (ECRI) studies demonstrate a slight uptick in inflation in the US by their US Future Inflation Guide. But it is not a real concern for the immediate future, as the index is at a 51 year low. Likewise, the inflation index guides for the Asian and European governments show decreases in inflation (according to ECRI). So much so that the European Central Bank continues, since the fall of 2008, to lower its key interest rate: now set at 1.0%. Similarly, the US sees no inflation for 2009 and probably 2010 as they set the May 1 inflation rate for the I bond to 0%; in addition, there will be no Social Security cost of living increase for retirees for 2010. No imminent inflation says Uncle.

But one must wonders about the trillions and trillions (over 8.1 says Walker Todd of the American Institute for Economic Research) of dollars put into the bail out and stimulus packages. Sooner or later this has to come back and bite us. Inflation, or worse—hyperinflation is due to occur. Unless, Uncle plays his trump cards. Nevertheless, the printing presses at the Treasury are running day and night. It may take two to three years to play out. But it will come. Once again we will experience too many dollars chasing too few goods. The problem here for investors is that it is difficult to protect your assets. History shows that the customary hedges don’t work too well.