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With much of this "wealth" built on easy credit, though-and with the bursting of the stock market bubble, attendant contraction in business credit conditions and such-a frightening new word entered the American vocabulary: DEFLATION. Suddenly, with consumers also just beginning to pull in their horns (or in the alternative, sit on their wallets until the next sales materialize) fears have grown that we've only just begun a Japanese-style process that will see years' worth of this most feared of "flations" solidifying its grip on us.

Leading the charge against this scourge is Fed Chairman Alan Greenspan who-preferably joined by other world central bankers, but willing to go it alone if need be-is valiantly fighting back with the current flavor of the moment: REFLATION. By opening the monetary floodgates, not to mention telegraphing the intention to do even more if need be, the central bank is hoping that the sheer volume of new money will move a somewhat unwilling economy forward at a faster pace. As this New Year begins, there is some guarded optimism that this newest part of the "flationary vocabulary" will be uttered even more as 2003 progresses and that, in the end, Greenspan will have slain the deflationary dragon.

Of course, figuring out who is most likely to win this battle-and which one (or more) of these "flations" will otherwise be the more dominant economic forces-is crucial to determining what you should do with your savings and investment dollars. A wrong bet too far in one direction could devastate your portfolio; a correct one could grow it nicely even in an otherwise lackluster environment.

Of all the possible "flations" which one, you ask, will carry the day-or, looking at it differently, cramp everyone's style-in 2003? That's a tough question; as you'll read further along in this month's issue where the markets themselves are concerned, it's virtually impossible to say (except where gold is concerned) until we know whether we're going to end up in a messy Middle Eastern quagmire or not. That aside, however, I'll make a prediction that might at first seem an equivocation; but which will likely be borne out by events. The answer to the question at the beginning of this paragraph is: all of them.

Just as the stock market has had pockets of incredible strength on the one hand and complete devastation on the other during the last few years so, too, will the markets and the broader economy again confuse pro and novice alike once more with their divergent behavior in the year ahead. Last year, the behaviors of both gold and the dollar would lead you to believe that the Fed was finally going to prevail, and that reflation-then inflation-would again become the dominant trend. The stock market told a different story, seeming to bet on further weakness in the economy and a continuing lurch toward a broader deflation. Fixed income added the exclamation point to that; the strong Treasury bond market combined with the shaky market for corporate debt voted overwhelmingly for the deflation/credit contraction scenario.

As for the months ahead, as already stated, the extent to which each of our "flations" is manifested will be determined in great part by how each is strengthened (or weakened) in the event of a war. The outcome will be decidedly different if we pull back from the brink, and-later on in the year-the imminent threat of war has been sufficiently minimized. With that caveat, here's how our candidates' "prospects" look:

This actually needs to be a two-parter; after all, the term inflation has a couple different connotations.

Its purest one is in regard to inflation being an increase in the money supply, particularly one that creates new dollars faster than the marketplace can absorb them. That the Federal Reserve has pulled out all the stops (well, ok, maybe not all of them yet, but quite a few) is indisputable. The growth of virtually every one of its confusing money supply measures has exploded, running recently at better than a 20% annualized rate where short-term measures are concerned. The federal funds rate is down to a paltry 1.25%, leaving a mere 1.25% to go before nominal rates are at exactly zip. And if you don't think such a thing can effectively happen, ask whether a few years back you ever thought you'd see them at these levels.

Just as important as the nominal level of rates, though, is the fact that the real federal funds rate (the difference between the nominal rate and the increase in consumer prices) has fallen even further into negative territory. And this assumes that the Bureau of Labor Statistics' Consumer Price Index reflects "real world" inflation, as that term is meant to convey its second (and more historically recent) meaning of higher prices for goods and services.

Economists and stock market bulls alike are proclaiming even louder now that this huge monetary inflation will lead to a re-inflating of the economy and put us back on the course to sustained, long-term growth. The argument is compelling; there has never been a time when real interest rates turned negative and stayed there for a while that the economy did not eventually respond. But those other times were not while, a) nominal rates for consumers were near rock bottom already, b) credit conditions for business were worsening, c) the level of existing indebtedness was already extreme, with both personal and business bankruptcies setting new records, and-most important-d) when foreign holders of substantial U.S. dollar denominated assets must ratify the policy.

But--so far, so good; the Fed's inflationary monetary policy has at the least kept the stock market at relative equilibrium of late, it's slowed down deflation in some areas, and encouraged reflation in others (chiefly the beleaguered energy sector so far.) In my opinion, however, the Fed will ultimately fail to reflate the entire economy for anything more than a brief interlude within the longer-term, secular unwinding we've started. But if things go well and we avoid a messy war, 2003 could be a year where-for a spell-Greenspan will be lionized as having reclaimed his old magical powers.

Now, more about price inflation. A lot of people assume that the rise in the prices of gold, oil and some other commodities-combining to cause the Commodity Research Bureau Index to jump some 25% or so in the last year-presage the kind of price inflation witnessed in the 1970's and part of the 1980's. In my view, they're wrong; or at best, premature; and elsewhere in my January, 2003 issue, I discuss what I have termed the "Commodities Fake-Out."

"Real world" inflation for the average American household is tough to gauge; yet, in spite of what I have to say about a possible false signal from commodity prices generally, the cost of living is certainly rising more for most of us than the lousy two or three percent that the BLS comes up with. As a well-done piece in the January issue of Kiplinger's quipped, ". . .if inflation is so sluggish that some experts are worrying about the possibility that it may go into reverse and produce deflation, why does it cost so darn much to live?

Consumer prices for many goods have indeed been softer in recent years. Much of that, however, has been a result of disinflation which, overall is healthy for any economy (but is sometimes mistaken for deflation, which we'll spend some time on shortly.) Disinflation comes about because of technology, increases in productivity, technological progress and more. If you adjusted/updated the cost into 2003 dollars, few today could afford one of the very first automobiles ever produced a century ago. Yet Henry Ford's assembly line and the economy of scale brought prices down to the common man's level in one of the best historic examples of disinflation. Many goods today have declined in price over time as well; not because that alone represents the economy's poor health, but merely that it, frankly, represents a form of progress.

Some are mistakenly looking at the declines, say, in personal computer prices as some evidence of deflation that must somehow be addressed. Likewise, the more recent decline in airline ticket prices is worried over. Neither of these in a market economy is any cause for concern, nor do they alone represent deflation. As Barron's Thomas Donlan remarked in that paper's December 9 issue when discussing this same subject, "In free markets, prices have entropy: They get lower because products and services lose energy to satisfy our endless aspirations. New ones are always needed. Economists shouldn't stand in the way."

While some goods have indeed been subject to this disinflation, some haven't; most noticeably, the food and energy areas that the BLS always likes to segregate from its figures because these items are "volatile." I suppose if you don't heat your home or put food on the table-but, instead, spend your money on a new knock-off P.C. every week-your household's "inflation" rate is rock bottom. Otherwise, I think you'll agree that your own cost of living is going up a Hell of a lot faster than two or three percent.

This is especially true if you pay school and property taxes, health insurance premiums or other health-related costs, or have a child (or grandchild) in college. Service costs are going up rapidly, and do not show any signs of slowing down. And of all things now, the battered telecommunications industry is testing Greenspan's reflation scheme by raising rates for long distance and other services, apparently to see if it can't get some of these extra dollars being churned into circulation in a roundabout way.

Bottom line in all of this: Monetary inflation will continue at a healthy pace in 2003; but it won't be enough to do anything more than give the broad economy and markets a brief respite, and a false sense of security. Consumer price inflation will remain well above the BLS numbers for most, even if the economy continues to stagnate. On that note-though few others have talked about it, given their proclivity to parrot what's on the boob tube-I think we already have the stagflation I've long said would be coming back.

As with inflation above, we must come at the subject of deflation from two different directions. First, we'll talk about prices for goods and services.

Much is stressed right now about pricing power. With few exceptions, you don't want to be an investor right now in companies that do not have the ability to pass on higher costs to consumers. Some areas of health care, educational services, and even energy are attractive right now. On the other hand, it's my opinion (regardless of the fact that they've recently rallied) that one needs his head examined if he is interested in the P.C. and related equipment makers, as that sector has no pricing power whatsoever.

Where the decline in some prices begins to get worrisome is when it passes from the positive market/productivity effects of disinflation discussed earlier, to something nasty. There's evidence of that on a couple fronts:

Foreign "competition"-Just as the old radioactive dinosaur crossed the ocean and wreaked havoc on the U.S. in a couple of its big screen manifestations, so too has the monster of deflation invaded the U.S. It has done so in the form of cheap imports from a host of countries; not only Godzilla's home port of Japan, but from other nations as well. Most notable among these over the last few years has been China, which has been increasingly "exporting deflation" to the U.S.

After a while, affected companies are unable to raise prices, and have to lower them to keep any kind of sales level going. Profits vanish, forcing companies in affected industries to turn around and slash costs. These measures mean that people are laid off, capital spending or information technology (IT) spending is reduced or eliminated, and factories are shuttered.

The trouble with this insidious a brand of price declines is that it spreads; fewer employees and higher unemployment rolls mean weaker consumer demand. That in turn means even tougher sales environments, lower margins (or greater losses) still, more "downsizing," and so on. A vicious circle begins to gain momentum; one which all the central bank efforts at reflation are all but powerless to stop if it goes too far.

Credit contraction/debt implosion-Of all the nightmares of central bankers, the one where banks and investors refuse to lend and consumers are no longer willing to borrow is the worst. A fractional reserve system such as ours must continually be expanding new credit to somebody. This allows credit and economic activity to expand, and existing debts to be serviced. It's when new activity slows sufficiently to threaten even the servicing of existing debt that the most destructive aspect of deflation manifests itself in an outright implosion in credit.

Just as with the vicious circle of price declines leading to more layoffs leading to reduced business spending, etc. above, weak economic growth (let alone a contraction) in an environment where everyone is already in debt up to their eyeballs starts its own vicious circle. Now the dominoes that are falling are of businesses that can't pay their bills, and fail. That eventually cripples others, some of whom also fail.

This has already been happening in the corporate sector most acutely; next to join in, according to some of the most pessimistic forecasters, are households. Rising home equity and low interest rates have combined to largely mitigate the stock market's blowing off of $7 trillion in phantom wealth. But there is absolutely no room for error. Any more of an increase in unemployment, any additional external shocks, any more delay in a strong rebound, any significant rise in market interest rates will slowly tip more households into the vortex of a deflationary implosion of debt-and that debt's related asset base. And once that starts…once that takes hold with increasing numbers of households in addition to the businesses already being affected…it's over. All the Fed's stimulus will count for little, and the slide into, perhaps, something even worse than Japan's mess will have (if it already isn't) become irreversible.

In summation, don't let either the Fed's bravado or the fake-out being delivered by the CRB Index lull you into a false sense of security that deflation's biggest threat is behind us. It's not. We'll have continued price deflation in some sectors, and-especially if one or more external shocks and/or war spook consumers yet again-an acceleration/broadening of the debt deflation/implosion that, so far, has been confined most dramatically to the telecom and energy sectors.

As for monetary inflation, we'll continue to get all the Fed thinks we need, and then some. But at best, it will just further postpone the digesting of the trillions in debt that are still out there. At worst, it will fuel more price inflation, taking us back closer to a 1970's-type scenario of a lethargic economy and a rapidly rising cost of living. . .

The preceding is excerpted from the January issue of The National Investor; for more information, go to www.nationalinvestor.com

Chris Temple
Editor, National Investor

January 24, 2003