Just as water is formed by the basic elements hydrogen and oxygen, deflation has its own fundamental components. Last week we started exploring those elements, and this week we continue. I feel that the most fundamental of decisions we face in building investment portfolios is correctly deciding whether we are faced with inflation or deflation in our future. (And I tell you later on when to worry about inflation.) Most investments behave quite differently depending on whether we are in a deflationary or inflationary environment. Get this answer wrong and it could rise up to bite you.

The problem is that there is not an easy answer. In fact, the answer is that it could be both. Today I got another letter from Peter Schiff, who seems to be ubiquitous. He says the rise in gold is because of rising inflation expectations among investors. Gold is predicting inflation. Maybe, but the correlation between gold and inflation for the last 25-plus years has been zero. I rather think that gold is rising in terms of value against most major fiat (paper) currencies because it is seen as a neutral currency. The Fed and the Obama administration seem to be pursuing policies that are dollar-negative, and they give no hint of letting up. The rise in gold above $1,000 does not really tell us anything about the future of inflation.

In fact, it is my belief that if the Fed were to withdraw from the scene of economic battle, the forces of deflation would be felt in short order. The answer to the question "Will we have inflation in our future?" is "You better hope so!"

I wrote in 2003, when Greenspan was holding down rates too long in order to spur the economy, that the best outcome or endgame over the course of the full cycle would be stagflation. I still think that is the most likely scenario. The Fed will fight deflation and knows how to do that. They also know what to do when inflation becomes too high. But there is a cost.

"A severe global recession will lead to deflationary pressures. Falling demand will lead to lower inflation as companies cut prices to reduce excess inventory. Slack in labour markets from rising unemployment will control labor costs and wage growth. Further slack in commodity markets as prices fall will lead to sharply lower inflation. Thus inflation in advanced economies will fall towards the 1 per cent level that leads to concerns about deflation.

"Deflation is dangerous as it leads to a liquidity trap, a deflation trap and a debt deflation trap: nominal policy rates cannot fall below zero and thus monetary policy becomes ineffective. We are already in this liquidity trap since the Fed funds target rate is still 1 per cent but the effective one is close to zero as the Federal Reserve has flooded the financial system with liquidity; and by early 2009 the target Fed funds rate will formally hit 0 per cent. Also, in deflation the fall in prices means the real cost of capital is high - despite policy rates close to zero - leading to further falls in consumption and investment. This fall in demand and prices leads to a vicious circle: incomes and jobs are cut, leading to further falls in demand and prices (a deflation trap); and the real value of nominal debts rises (a debt deflation trap) making debtors' problems more severe and leading to a rising risk of corporate and household defaults that will exacerbate credit losses of financial institutions."

- Professor Nouriel Roubini of New York University