Deflation! Inflation! We just can't call the whole thing off…
All the best bust-ups polarise opinion: Lennon versus McCartney. Apple versus Windows. Coke versus Pepsi. Ant or Dec.
But those debates are child's play compared to the inflation versus deflation debate that still rages on trading floors, in the corridors of power, and across the Fool's discussion forums.
It's not just that excess inflation and deflation have big consequences for the economy and so our daily lives, with deflation being particularly pernicious.
It's that both sides can't be right.
You may prefer BP (LSE: BP) while I prefer Royal Dutch Shell (LSE: RDSB) but we'll both do well if the oil price goes up. In contrast, if you bet heavily on either rampant inflation or a lurch into deflation, your portfolio will be smashed should you get it wrong.
The persistent low yields on Government bonds such as UK gilts for example only really make sense if inflation remains subdued for years, or if we get mired in deflation. You won't actually lose money in nominal terms should inflation take off -- provided you hold your gilts to maturity -- but that will be cold comfort if inflation hits five or 10%.
The deflationist's manifesto
This time last year the deflationary viewpoint was undoubtedly in the ascendant, as demand collapsed around the world.
With GDP falling off a cliff, commodity prices that had exhibited bubble-like behaviour fell to earth. Inflationary pressures discussed to death in 2007 and early 2008 evaporated. Instead, a second Great Depression seemed possible.
But when the credit crunch dug deeper, central banks took decisive and extraordinary measures to get money moving. Credit conditions eased, the stock market rallied, and investors began to see green shoots, leading to dwindling numbers of deflationists.
But not everyone deserted the cause. Government bonds are still suggesting inflation isn't a problem, and deflation is already here in some countries. Even the UK -- which attracts rising prices like Rod Stewart attracts wives -- has seen deflation for several months by the RPI measure, albeit it largely due to mortgage costs, which have fallen with the slashed base rate.
Nobody can deny there's been some affect from monetary stimulus, with all kinds of key numbers having been revised upwards for months.
Only this week the IMF revised its estimate of UK growth in 2010 upwards to 0.9%. Olivier Blanchard, the IMF's chief economist, said the chance of global depression was 'all but eliminated'.
But deflationists see most green shoots as little more than an artefact from shoving money into a financial system that doesn't really want it.
They note massive over-capacity (factories mothballed, unwanted houses in the US, and jobless workers -- Goldman Sachs estimates this equates 6% of GDP, which is as bad as in the Great Depression) and see consumers drawing in their horns.
As easy money dwindles (so-called 'M3' money supply is shrinking here and in the States) they point to Japan's long battle with deflation as our future.
Inflationary talk
"Tosh!", say the inflationary cheerleaders, many of whom see more potential for hyper-inflation as a consequence of excess liquidity than benign inflation, let alone deflation.
Quantitative easing -- which the UK has indulged itself in to the tune of £175 billion -- is just a fancy way for money printing, they argue, and we all remember from our schooldays what happened next.
The threat of deflation is yesterday's news. Commodity prices bounced off their lows months ago, and assets like equities and corporate bonds have surged. Even house prices have bottomed.
What's more, wages are still rising and -- crucially -- the man in the street expects inflation not deflation down the road. Deflation only really becomes imbedded when consumers close their purses to wait for lower prices. There's little sign of that in the West as yet.
What's a Fool to do? If you strongly believe we're going to see either sustained deflation or rampant inflation, you can align your portfolio accordingly.
Dealing with deflation
The best asset to own in deflationary times is UK, US or European government bonds. Their fixed payments become increasingly valuable as prices fall each month, so the yield is driven down, making your bonds more valuable.
Cash is also good at times of deflation. Your savings can buy more week on week, so even if interest rates are zero, you're effectively getting a return on your money.
Corporate bonds also offer fixed interest and the potential to rise in value like government bonds, but they're far more likely to go into default.
The economic landscape will be grim indeed if deflation becomes embedded, with companies and consumers alike struggling with the escalating cost of debt. Think carefully whether higher corporate bond yields will compensate you for the risks.
Insurance against inflation
If you predict an inflationary shock, you've got more options.
Index-linked government bonds guarantee a real return on your money, since they're linked to the underlying rate of inflation. You can also put money into National Savings Index-Linked Savings certificates.
The classic inflation hedge is gold -- some would argue its strong rally is a harbinger of higher prices to come. You can buy physical gold or take a position via a gold ETF, or even buy gold mining shares.
Shares are usually considered a reasonable asset to own in inflationary times, although the evidence is not clear cut.
As prices rise, companies eventually benefit from higher reported profits. But over the short run, high inflation (and higher interest rates) aren't like to be good for the stock market.
Finally, property can be a hedge against inflation; the price of your house rises even as the debt on it is steadily eroded away. But remember we'll see higher interest rates with inflation, so be sure you can afford increased payments or else fix your rate in advance.
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