The opposing forces of inflation and deflation are in the spotlight this spring. Inflation occurs when the government spends more money than it takes in. The economy heats up and prices begin to rise. Deflation becomes dominant when the economy weakens and many businesses fail. Money becomes more valuable and prices begin to fall.
Until recently, rising inflation was the stronger of the two trends. But when the credit crisis started, deflation started to gain the upper hand. Economists are now divided about which monetary situation will prevail over the next few months.
The inflation/deflation question is important because it creates different winners and losers. With inflation, investors can make money if they buy precious metals, commodity stocks, foreign currencies, and other solid assets that go up in price. At the same time, cash slowly loses value.
During deflation, however, prices of most hard assets go down and the value of cash rises. The way to make money is to use increasingly valuable cash to buy high quality assets at steep discounts, and sell them for a profit when prices eventually recover. Some investors are beginning to do just that in a few real estate markets that appear to be oversold.
Longer term, we think inflation will prevail and the price of gold, commodities, and so on, will resume their upward courses. Nearer term, however, we think deflation may create more opportunities for gains. If we are correct, you should have more cash available than you would ordinarily want to hold when interest rates are very low.