Throughout much of the past year we have been hearing about the impending onset of inflation. Realistically, how could it not happen? The Federal Reserve had instituted Quantitative Easing to pump more money into the economy to get commerce flowing again. At the same time they have kept interest rates at very low levels to try and stimulate lending. Both of these factors would ultimately cause run away inflation, right? At least that is what all the experts in the financial media were telling us.
The problem is that while the Fed has tried to push money into the economy, it isn’t flowing through to the consumer in terms of lending, new businesses or job creation. This leads us to the latest word to be discussed by the media and economic experts, deflation. Deflation is when the price of goods fall because of lower demand. Simply put if a consumer feels that prices are going to drop they delay their buying. This is a trickier situation for central banks around the world because they can’t force consumers to spend. Some may say that deflation is a natural corrective process for a consumer still in the deleveraging process. The problem as the government sees it is that economic activity remains very slow during these periods.
So how does this affect you and I? We are definitely in a tug of war, with some items continuing to drop in price (think realestate, electronics, etc) and other items maintaining their prices or even going up (food / groceries). But more importantly if either scenerio takes hold it definitely affects how you should be invested. During inflationary periods hard assets (real estate, gold, commodities) will rise but bonds will fall as the Fed tries to combat to much inflation by raising interest rates. On the opposite side, during deflationary periods bonds are a safe haven as investors seek out safety and any type of return. With no clear forecast on what is ahead in the economy it means that you must consider both extremes and diversify your portfolio accordingly. By allocating certain percentages of your investments to all of the asset classes: stocks / bonds / commodities / cash, you give yourself better opportunity to participate on the upside while lowering downside exposure.