Goldilocks Doesn't Live Here Anymore

"The Fed is hell bent on preventing what happened in Japan from happening here," the economist said. "So there is an enormous bias towards being inflationary over the next five to 10 years."

Inflation is a friendlier environment for debtors. Because the principal amount of a loan is fixed, increasing inflation nibbles away at the debt burden by reducing the future value of each payment owed. This allows for debt service without requiring a catastrophic curtailment of spending.

Jeffrey Knight, chief investment officer for asset allocation funds at Putnam Investments in Boston, agrees that the Fed is fighting harder to prevent deflation than inflation. Still, he doesn't expect much of a rise in inflation over the next two years.

Most companies have had a tough time raising prices, resulting in margin pressure at firms such as General Mills (GIS Quote), Unilever (UL Quote) and Colgate-Palmolive (CL Quote). Meanwhile, higher productivity makes it easier for other firms to cut costs and become more efficient instead of trying to pass along higher input costs.

"We are in a stable, low-inflation environment and nothing that's happened so far this year changes that," Knight said. Still, the Fed's strategy is to "err on the inflation side" by raising rates slowing rather than risk sliding back toward deflation.

Fund firm T. Rowe Price in Baltimore has data to back up the assertion that runaway deflation is the worst-case scenario, at least for stock investors. It compared periods of mild to severe inflation and deflation quarter by quarter, going back to 1926.

Stocks did best, averaging returns of more than 20% a year, when prices were flat to slightly falling, the firm discovered. Stocks returned above 15% when inflation rose by as much as 3%. Those environments account for just about half of the quarters studied.

Returns fell off quickly as inflation increased, and were under 5% if inflation exceeded 12%. But the only scenario that generated an average loss was during periods of deflation of more than 2.5%. Stocks lost more than 5% on average during those times.

For the record, Alan Levenson, chief economist at T. Rowe, says the economy is "on pretty strong footing" and he expects inflation will increase to as much as 2.5% next year.