I have written a fair bit about inflation in the past, starting with a post about inflation versus deflation during the financial crises in 2008, which I then followed with three posts in 2009. We are now finding ourselves in 2014 and so far there are no signs of inflation. That would seem to say that Paul Krugman had this one right and people who were worried about inflation had it wrong. Then again that would be a classic case of a turkey argument where we confuse an absence of evidence (it has not happened yet) with an evidence of absence (it can’t happen). So let’s instead re-examine both cases a bit.

The deflation case comes from observing that we have a lot of downward pressure on cost and prices. Global competition in product markets that are being made ever more efficient by the Internet are pushing down prices. Add to that sharing services (cars, apartments, stuff) which reduce the demand for new purchases. At the same time increased automation, the globalization of the labor market and high unemployment rates are all keeping wages way down. So stuff keeps getting cheaper and we are finding ourselves with deflation which potentially accelerates as people wait to spend money until things get even cheaper in the future. The money created by the Fed is seen as harmless because we are in a liquidity trap in which banks aren’t lending.

The inflation case focuses on exactly that same vast amount of liquidity that has been created by the Federal Reserve bank by buying up assets. The argument goes that the Fed will fail to shorten its balance sheet in time. That could happen either by not attempting to do so or by failing when they try as the assets turn out not to have any buyers. In that case all the extra money will actually hit the real economy instead of mostly sloshing around the financial markets and inflating assets such as internet and emerging market stocks (really anything that has a growth story). One way this could happen is through a massive loss of confidence, eg in the form of a bank run. Right now that seems like an outlandish scenario but it could get set off by an exogenous shock such as the latest bird flu spiraling out of control (pick your favorite doomsday scenario).

So what should one be doing with one’s personal balance sheet? If you have debt, the answer is pretty easy: make sure it is fixed rate or the rate can increase only slowly (or you have the ability to pay it back). On the asset side things are a lot trickier. I am not aware of a good strategy that hedges against inflation and deflation at the same time. So my personal stance is massive diversification that includes holding some cash, some stocks, some commodities, some real estate, etc. The only thing I don’t hold is longterm debt (at fixed rates).