Does the Future Hold Inflation or Deflation?

I’ve been reading a bunch of doom & gloom books on the U.S. economy lately, which I plan to discuss them in a future post. One of the key questions that seems to be percolating at the moment though is the likelihood of a prolonged economic downturn, and whether the future holds inflation or deflation.

Inflation is the rise in the general levels of prices of goods and services over time (source: Wikipedia). The U.S. has experienced mild levels of inflation, around 2-4% overall, depending on the method used to calculate inflation and the category you are referring to.
Inflation  has the following adverse effects:

• It destroys the assumption that money is stable.
• High inflation may cause some to forgo saving and investing and instead hoard goods (because the prices could go up tomorrow).
• Inflation can cause tax increases, and inflated salaries may be taxes at higher rates.
• Inflation can aid those with fixed payments over a long period of time, because the loan will be repaid with dollars that won’t buy as many goods.
• Inflation can cause the workers and unions to demand higher pay, which in turn may cause higher inflation (i.e. price/wage spiral)

I would like to know if high levels of inflation are also (typically) accompanied by high interest rates. I would also like to know if low risk investments typically provide a real rate of return in times of high inflation. My assumption would be that low risk investments, like CD’s and short term bonds, typically still provide a real rate of return. If that is the case, and if times of high inflation are accompanied by rising interest rates, than the debt-free consumer with cash in the bank has little to worry about (except job loss).

Deflation
Deflation, as you might suspect, is the opposite of inflation. With less money floating around, general prices of goods tend to fall. And so do incomes. Deflation can be a problem in a modern economy due to the “deflationary spiral”. Similar to the price/wage spiral inflation, a situation can develop that causes an economy to deteriorate further. In the case of a deflationary spiral, lower prices cause lower production, which causes lower wages and layoffs. Then people can’t afford goods, demand continues to decrease, and prices erode further.

Inflation is defined as an increase in the money supply, whereas deflation is defined as a reduction in the money supply (this is the short story). There is an on-going debate as to whether an increase or decrease in available credit should also be included in the definition of inflation and deflation.

Clearly fed at least tries to control the money supply to keep inflation modest at most. What I’m wondering, however, is what happens when the money is available but people and companies choose to avoid using the funds. Like an untapped credit card, the availability of credit does not necessary mean people will start buying more goods and services.

I would like to know your opinion on the topic. Do you expect inflation to increase substantially as part of the current economic woes, or do you think deflation is more likely?

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