Inflation? Deflation? Hedge Your Bets

Investors who are trying to sort through the economic news and figure out which way to go can't be blamed for feeling like Dorothy when she asked the Scarecrow how to get to Oz, and he pointed one arm in each direction. One group of economists tells us our biggest worry is inflation, and the other group says we're in for a period of deflation.

The two scenarios dictate entirely different investment strategies. Commodities and real estate do well in periods of inflation; bonds are a natural for deflationary times. It's a mistake to pick one road. What we need to do is understand the situation and then hedge our bets. One investment shows some promise in helping us to do that: Treasury inflation-protected bonds, or TIPS. But first, let's look at the evidence.

Inflation means rising prices. But it hasn't been a threat for so long that many investors don't remember how it wrecked the economy and markets in the 1970s. Stocks were a disaster; so were bonds, where investors saw losses of 30% to 40%. Mortgage rates hit the mid- to high teens. I got a 14% mortgage on my first house and considered myself lucky. Some economists said inflation was an intractable problem. Then Paul Volcker was named Fed chairman, and he broke the back of inflation by raising interest rates and limiting the flow of money into the economy.

Is Inflation Whipped Now?

This scenario could repeat, but it's unlikely. Fed policymakers have learned a lot of lessons since 1980, and those lessons have held inflation down to a rate of 1% to 3%. But those who argue the inflation scenario point out that home prices have held steady during the current recession, that price cuts are concentrated in energy and hard goods such as autos, and that if you take out food and energy, the consumer price index is actually increasing at nearly 5%. The inflation team also argues that the costs of services, especially for medical care and college, are escalating rapidly. I saw that when I got my health insurance premium increase notice this week; it is up more than 30% from when I got the policy four years ago. ...