Is it inflation or deflation that investors need to worry about?

Gail Bebee is the author of No Hype - The Straight Goods on Investing Your Money. She can be reached at gbebee@gailbebee.com and her website is www.gailbebee.com. This is part 11 of a 12-part series for people that are new to investing on their own.

I am confused and I'm sure many of you are too. One day there's an economic report that declares we are on the edge of a deflationary spiral; the next day there's another one telling us that inflation is on the horizon. Our future investing success may well ride on making the right call on inflation v. deflation as each requires a different investing strategy. Who then to believe?

Given that trained economists can't even agree on the inflation/deflation question, might not someone unencumbered by economic indoctrination shed some welcome light on this matter?

That's what I hope to do in this article. I'll start with a brief synopsis of the two economic phenomena, state my personal conclusion on which will prevail, and end with some thoughts on investments which would work in the scenario I believe will unfold. (Disclosure: my academic training in the dismal science consists of an introductory economics course at university, and that was more than a few years ago).

Economists tell us that deflation exists when the prices of goods and services decline for a sustained period of time. It can be caused by a reduction in the supply of money or credit such as we've seen in the recent recession. On first blush, deflation sounds good to the average consumer. Who doesn't want to be able to buy more stuff with the same amount of money? However, taken to its logical conclusion, it's a scary scenario. If we all delayed purchases waiting for prices to go down, economic activity would grind to a halt. Companies would stop making things. Jobs would disappear. Your mortgage, car loan or other debt would become a larger and larger proportion of your personal budget. Not a pretty picture.

Deflation can be cured by pumping money into the economy and making it easy for people to get credit to open or expand businesses, such as by lowering interest rates. And that is what central banks around the world have been busy doing over the past year to combat the recession.

However, this is a tricky proposition. If too much money floods into the economy and there are too few goods available, prices rise, and inflation takes hold. Inflation is a different kind of poison for consumers. While debt decreases as a percentage of your personal budget, your purchasing power falls. If your wages don't keep up, you may not have enough money to buy even basic necessities.

Which brings us to the current state of affairs. There's been tons of money pumped into the global economy to stimulate economic activity. The government of Canada is among the countries that have piled on new debt to do so and now need to get spending under control. Politicians will have to make some tough decisions. Will they increase taxes, decrease services to citizens or print money to pay off their debt?

This is where I have a leg up on the economists, having spent several years in a previous life managing regulatory issues for a major Canadian corporation and observing the political class in action. There is a rare politician whose goal in life is not to get re-elected. Given this fact, the choice that governments will make to address their debt problem is clear to me: they will print money. And that means inflation, not right away, but not too far down the road as economic activity picks up.

With an inflationary economy on the horizon, what should investors be buying for their portfolios? Owning the currency of any country where the printing presses are busy cranking out money is not a good idea: the money will lose value over time.

You want to own hard assets, things like gold and other commodities, commodity-related stocks, real estate and the stocks of companies with the ability to raise their product prices at or above the rate of inflation. These investments all entail some risk.

If you want "safer" fixed income, consider real-return bonds, bonds with a built-in adjustment for the inflation rate. A real-return bond exchange-traded fund such as XRB, iShares Canadian Real Return Bond Index Fund , which has a management expense ratio of 0.45 per cent is a cheap, easy way to accomplish this. You could also consider the relatively new Inflation-Linked Bond Fund (MER 0.8 per cent) from renowned fixed-income mutual fund company, Phillips, Hager & North. It is also possible to buy real-return bonds directly through a discount or full service brokerage.

So is it inflation or deflation that we need to worry about in the coming years? No one really knows the answer to this question yet. Probably the best approach is to maintain a diversified portfolio and keep a watchful eye on changes to the Consumer Price Index (CPI). If the CPI rate rises above 2 per cent and shows signs of accelerating, start to adjust your portfolio for an inflationary world. If I'm wrong and deflation takes hold, cash is king.

Special to The Globe and Mail

Gail Bebee is a personal finance speaker and the author of No Hype - The Straight Goods on Investing Your Money. She can be reached at gbebee@gailbebee.com; her website is www.gailbebee.com