Pick Your Poison: Inflation, Deflation, Stagflation

Analysts see possible scenarios for each of these to strike the U.S.

economy. Stay alert and invest accordingly

Will the real 'flation please stand up?

Experts are arguing about where the U.S. economy is heading as the global financial system tries to right itself. Is it on the path to inflation, deflation, or, worse, stagflation? Rising unemployment and excess production capacity are making it hard for the U.S. economy to climb out of recession. And that, in turn, is putting a strain on pricing power and wage growth—raising fears of deflation, which develops when a broad decline in prices amid falling demand feeds further price-cutting.

But what happens if the Federal Reserve's efforts to jump-start the economy take effect? Stimulus to the tune of $787 billion is supposed to rev up economic engines. Prices could climb too high as too much money chases after available goods and services—the classic formula for inflation.

"I describe [the potential dangers in] this economy in the form of a snowy Minnesota road," says Peter Rekstad, a financial adviser at TruNorth in Oakdale, Minn. "A car slid off the road into the deflation ditch. The way out of the ditch is to get a bunch of friends pushing while you rock the car back and forth. The big danger is that you get out of the deflation ditch and race across the road into the inflation ditch."

Or to take Rekstad's analogy further, say a car is straddling the road, with its wheels mired in both ditches at once—the worst of both worlds. That situation, where growth slows while inflation soars, is known as stagflation.

Here's an investor's guide to protecting your portfolio from these three forces.


Deflation is the threat dominating headlines. "You've got a strong supply of goods and weak demand. That's a recipe for prolonged deflation," says A. Gary Shilling, economist and author of Deflation: How to Survive & Thrive in the Coming Wave of Deflation (McGraw-Hill (MHP)). The problem is deflation's ripple effect: When banks stop lending, businesses stop expanding and wages fall. Consumers stop spending, which pushes prices lower. Why won't massive stimulus pull the economy out of the deflationary lane? Shilling fears that the U.S. government's economic tampering will have a "Big Brother effect," hurting innovation and permanently curbing growth.

The Signs

The surest sign of deflation is a decline in the consumer price index, which tracks the prices of consumer goods and services. But it's hard to ignore lower real estate values, which aren't in the CPI. Home prices fell more than 18% in 2008, according to the S&P/Case-Schiller U.S. National Home Price Index. Another deflation indicator: the higher savings rate, which we're seeing for the first time in 25 years. Shilling expects the savings rate to rise from 4.2% to 10% in the next decade.

Investment Strategy

"Quality is paramount in deflationary markets," Shilling says. He thinks most investors should be in short-term certificates of deposit or money-market funds. Those with a 10-year time horizon should also buy tech stocks, such as semiconductors, he says. Companies facing deflation can't cut prices and must boost productivity through technology.


The Argument

Many of the economists and financial advisers polled by BusinessWeek for this story believe the huge amount of money being pumped into banks by the Federal Reserve (chart, right) makes inflation a real threat. Hans Olsen, chief investment officer for JPMorgan Chase (JPM)'s private wealth management business, says the stimulus plan ultimately will lead to higher inflation. However, total inflation is basically nonexistent at -0.4%. The trick is figuring out when it will be a problem. "The nasty thing about inflation is that it's insidious," Olsen says. Banishing inflation from the economy once it is "infected" is hard.

The Signs

The leading indicator used to measure inflation is the CPI. Commodity prices, particularly those of oil and copper, are another bellwether. One indicator Olsen tracks is government debt as a percentage of gross domestic product, which he sees surging from 40% to 80% over the next few years.

Investment Strategy






Stagflation is caused by the combination of slow growth and surging inflation. Slower growth will come from extreme caution by lenders, households, and businesses, while a shortage of production capacity will create inflationary bottlenecks, argues Mohamed El-Erian, chief executive officer at Pimco. "Stagflation will be part of the new normal," he says.

The Signs


Investment Strategy


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