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.
But the other group of economists argues that the real concern is deflation, or decreasing prices. That may sound good, but deflation is very damaging, as Japan has learned recently. Wages go down and unemployment goes up, as it did in the Great Depression. If you have a mortgage or credit card debt, every dollar you pay back is worth more than the dollar you borrowed. Inflation is troublesome; deflation causes revolution.