NEW YORK -- Global investors have been pummeled so hard by steep losses in financial markets that some have developed a split personality: one that agonizes about deflation even as the other frets over future inflation.
The two threats appear contradictory, but may yet prove to be related. Most immediately, prices on everything from real estate and stocks to gasoline and consumer goods are plummeting, creating the very real danger of a deflationary spiral.
At the same time, there is a strong risk that the Federal Reserve's effort to rescue the economy by pumping cash into the financial system will lead to resurgent inflation down the line, especially if the central bank waits too long to withdraw the vast emergency lending programs deployed to fight the crisis.
"The choice over which fear to harbor depends on the investor's time horizon," says Milton Ezrati, chief economist at Lord Abbett. "The economy could ultimately face a significant inflationary threat unless the Fed can absorb this excess liquidity quickly as this crisis passes."
The divide is evident even within the Fed itself. The dominant forces at the central bank, led by Chairman Ben Bernanke, view the precedent of the Great Depression as a lesson learned. They believe the greater peril is a world of continuously falling asset prices and rising unemployment, a vicious downward spiral that policy might find hard to combat.
This camp also draws lessons from the case of modern-day Japan, whose government is viewed by U.S. policy-makers as having waited too long before taking decisive action, thus prolonging the country's pain.
"Deflationary pressures are both building and spreading," argues David Rosenberg, chief economist for North America at Merrill Lynch. "It will literally take years of fiscal and monetary pump-priming to bring these measures of economic slack to levels that will precipitate the next inflation cycle."
That concern was being echoed by global industry leaders. Jeff Immelt, chief executive of the sprawling General Electric Co (GE.N), warned quite bluntly on Friday: "Deflation is out there."
Fed officials, having severely misjudged the magnitude of the crisis in its early stages and loathe to repeat past mistakes, finally reacted in force, expanding credit to the financial system to the tune of $1.4 trillion in just over a year.
However, there is growing internal dissent from the presidents of regional Fed banks, who have tended to be more hawkish on inflation and have become increasingly vocal about the need for a coherent exit strategy.
Charles Plosser, from the Philadelphia Fed, argued as much in a speech last week. "Our aggressive lending, while intended to help the economy and financial crisis recover, poses its own set of challenges," Plosser said.
His Richmond counterpart, Richard Lacker, went further, criticizing the actions of his peers for stepping too far outside its appropriate policy realm, thereby endangering the integrity of the central bank's mission. "Mixing monetary and fiscal policy is fraught with risks," Lacker said.
THE MUDDLED MIDDLE
Strange thing is, both views could be right. Economists say that while deflation and inflation are often depicted as two extremes in a spectrum, the two patterns are actually closer in nature than one might think.
Both are emblems of a dysfunctional economy. Both are marked by an ongoing and deeply detrimental reassessment of value in the economy.
That has certainly been the case in this crisis. Americans have seen more than $5 trillion in housing wealth evaporate while a monumental stock market crash has wiped out an additional $6.7 trillion. The result: cash-strapped consumers have slashed spending and hoarded cash in a dramatic reversal of preceding decade.
"U.S. consumers' current debt load is estimated to be approximately $2.6 trillion, which ensures that deleveraging to manageable levels may take until 2011 or beyond," said Ben Pace, chief investment officer at Deutsche Bank Private Wealth Management.
Such forces are, indeed, unequivocally deflationary. Some of this is already evident in consumer price data, which showed a 0.7 percent decline in December alone. Yet some analysts contend these drops may be ephemeral.
In times of turbulence, the value of money is a malleable concept, crucially dependent on the public's confidence. If trust in the worth of the almighty dollar were somehow compromised, all the money folks had been stashing away would flood the economy in a scramble for hard assets.
This notion is elucidated, at its most extreme, by the case of Weimar Germany, beginning in 1919. The republic's troubles emerged at first as the result of periodic bouts of deflation that swept the world at the turn of the century. Eventually, the hoarded German marks made their way back into the financial system all at once, pushing prices skyward and giving rise to the iconic images of workers with wheelbarrows of worthless cash.
"Under a situation of hyperinflation, civil society is really damaged. The foundations of trust are completely shattered," said Bernd Widdig, director of Boston College's and the author of "Culture and Inflation in Weimar Germany."
Widdig goes on to stress that today's United States is nowhere near that level of insecurity. But with mistrust in the financial system growing by the day, the turbulent economic landscape must be treaded increasing caution.
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