Flation is not a word, but it is the suffix of both inflation and deflation.  Ruling out the middle ground, I’d say it’s very likely that we will see one of the two in a large way during the next few years.  Over the last half year, we have seen massive deflationary forces take hold of our economy and the economy of the world.  These forces were so strong that they eventually destroyed what many of us thought was a sustainable commodities appreciation, and turned the economies of the world upside down.  With no end in sight for the near future, many people are assuming that we will be in this downward deflationary spiral for a long period of time.  Those that don’t believe this theory holds water believe that, due to the Federal Reserve’s actions, we will see a long period of rapid inflation.  I’d like to present a different theory that I believe will be a more accurate prediction of the future.  The current state of the world economy is extremely complicated because so many of the models we had relied on for many years proved to not be as infallible as previously thought.  Many people were caught in this “black swan” type trap, but the important thing going forward is to think rationally in order to determine the most probable future.One of the biggest “truths” that we used to hold was the way we thought about monetary policy.  As we were all taught in our economics courses, whenever the Federal Reserve increases the monetary supply by lowering their target for the federal rates, we should expect this action to have an inflationary effect under normal circumstances.  Historically, this has been true… and for a large part of 2008, this did in fact occur.  Recently, however, we have seen a shift in this philosophy.  Ben Bernanke and the Federal Reserve have continued to slash their target for the Federal Funds Rate, but during this time period the backs of oil, gold, and all other commodities were broken.  On top of this, the real estate market, equity market and debt market also collapsed.  Massive deflation occurred, and Bernanke, the student of Japan’s decade long deflation, answered by lowering the Federal Funds Rate to a historic low of a 0.00% to 0.25% range.

Naturally, this did not have the desired effect for two reasons.  First, anyone who was paying attention to the Federal Reserve knew that Big Ben had been ignoring his own target by allowing the Federal Funds Rate to slip down to this level for more than a month ahead of the “official” rate cut announcement.  This was only big news to the people that trade and invest on every CNBC’s commentators’ word, not to the intelligent investors of the world.  The only effect that this announcement had was a shift in the psychology of the average investor, which leads me into the second and more important point.

Ben Bernanke followed his Japanese case study to a T, but there was one variable that was not present in the Japanese “lost decade” that is the driving factor of the current deflationary environment we are experiencing: confidence, or more accurately trust, is no where to be found.  Formerly liquid markets are no longer so liquid… and even the largest and oldest of banks no longer trust each other.  This “freezing” of the financial markets more than negated Helicopter Ben’s actions.  What Bernanke failed to understand was that no matter how long you keep the printing presses running… all of that money sitting in vaults (or now in most cases electronically) in banks is depreciating in value; this is something that he does not have the power to fix.  This is like trying to fight fire with fire. In essence, he is only making the coming problems much worse.  Unless Bernanke can change the mindset of the banks, he has almost no power. These banks are using the TARP (Troubled Asset Relief Program) money to pay down debt, de-leverage and strengthen their balance sheets & Tier I capital.  I can assure you that the first concern of the banks is not to fix the United States liquidity problems to help out Big Ben.

The problem with Bernanke’s actions is that someday in the future confidence, and in turn demand, will be regained (this could be a while) and there will be too many banks with war chests that are far too large.  We have already seen the first part of the cycle occur with rapid deflation, but the second part includes rapid inflation that will be uncontrollable.  No one will know when this shift will take place, excluding possibly the heads of all of the large banks.  When they decide to make this money available for use, we will see inflation problems that will make the price increases of this summer look very tame in comparison.  In the mean time, no one will be spared, not even in hot sectors like information technology.

Many naysayers will question my predictions and ask how in the world I could even consider inflation a possibility at this point in time.  I would contend that things aren’t always as the media would portray them.  Rational and experienced investors know this”obvious”  prediction to be flawed, but it’s hard NOT to question your beliefs when 90% of the population believes otherwise.  The key here is to stay the course and not to be sucked into the hype; don’t let your eyes deceive you.  Printing money non-stop for a year (or longer, I don’t see him stopping any time soon) will have consequences.

Disclosure: None.