In Rounders Matt Damon plays a reformed poker shark forced back into gambling by circumstances. Damon's poker prowess lies in his ability to read other players and thus know what cards they have. Most professionals agree that the ability to size up opponents is a crucial skill needed to win at competitive poker. In these games, knowledge of human nature, not of the mathematical odds, provides the key advantage.

Predicting inflation also requires understanding the human actors con­trolling the situation. The rate of inflation is determined by the growth of the money supply. In the United States , the Federal Reserve controls the money supply. To make predictions about U.S. inflation, therefore, one must have a good idea of the future actions of the Federal Reserve.

Many people are willing to make bold predictions of future inflation rates to develop working forex strategies. On one hand, you find books about how to protect yourself in the coming deflation. On the other hand, some foresee an inflationary world where investors must buy gold to protect themselves.

I remain unconvinced by those who make clear predictions about a future inflation or deflation. U.S inflation rates will be determined by the future decisions made by the Federal Reserve. A prediction of inflation must be based on future decisions of the monetary authorities. Further­more, the current chairman, Alan Greenspan, was born in 1926, so he might not even make it to the end of his current term in June 2008. Thus, all longer-term investments will be affected by the inflation rate determined with a new chair of the Federal Reserve.

Consider the historical period between World War I and World War II. Between the wars, Germany experienced a hyperinflationary depression, while the United States had a deflationary depression. The German monetary authorities created huge amounts of money and destroyed the value of the German mark. The U.S. monetary authorities did not create inflation— quite the contrary, U.S. prices declined throughout the Great Depression.

These extremely different outcomes suggest that the people in power determine the inflation rate. Although this may appear obvious, it is possible that the German authorities had no alternative. Similarly, some believe the current Japanese monetary authorities are powerless to prevent the current deflation. To the contrary, Milton Friedman believes that the Japanese can end deflation by simply increasing the money supply. I side with those who believe that the individuals in charge of monetary policy determine the inflation rate, constrained, but not controlled, by circumstances.

Thus, a good prediction of inflation requires detailed understanding of the forces that will pull and push the people who determine inflation. Furthermore, as in high-level poker, inflationary predictions depend on the ability to predict human behavior. While it may be possible to predict the behavior of the next Federal Reserve chair, even before she or he is appointed, I have not seen a convincing prediction.

Missouri on to Inflationary Mind

Missouri is the "show-me" state, where residents are reported to wait for proof and not act on promises. When it comes to inflationary predictions, I suggest a show-me attitude. Rather than speculate on the future actions of monetary officials who have not yet been selected, a preferable financial strategy is: (i) based in the facts, and (ii) likely to perform well in either an inflationary or deflationary world.

First, let's look at the monetary facts. Figure 5.3 depicts U.S. money supply growth over the last decade. Monetary growth has accelerated, so the facts provide some support for those who predict rising inflation. Monetary changes create inflation only after some time, and the Federal Reserve may have planted some seeds of inflation that will sprout in the years to come. Both gold prices and the value of the dollar confirm that inflation may be stirring. Gold has risen from $250 an ounce to over $400 an ounce. Over a similar period, the dollar has fallen significantly against many currencies and to an all-time low against the euro. 17 These moves suggest that the Federal Reserve's loose money policy is decreasing the value of the U.S. dollar.

FIGURE 5.3 Is the Federal Reserve Creating Inflation Again? Source: U.S. Federal Reserve

The inflationary case is not, however, complete. First, money supply growth over the last decade is still slower than the rates of increase in the 1970s. Second, money supply growth has slowed. So perhaps the Federal Reserve's policy is perfect. This optimistic view is that the Federal Reserve created lots of money to soften the effect of the bursting stock market bubble. Now that the economy may be emerging from that dour period, the Federal Reserve is easing up on money growth. If this optimistic scenario is correct, then inflation need not reappear.

To repeat the mantra of this chapter as expressed by Milton Friedman, inflation is always and everywhere a monetary phenomenon. Thus, as long as we keep a clear eye on money growth, we should have early warning of any major change in inflation. If money growth increases, then inflation will follow and investments should be in tangible assets including gold and land, and in currencies other than the U.S. dollar. If deflation becomes likely because of slow monetary growth, then finan­cial assets, particularly certain bonds, should do well. For example, the simple U.S. Treasury bond, even with a yield of just 5% per year, could be extremely profitable in a deflationary environment.

Buy Your Inflation Insurance at Irrationally Low Prices

In addition to looking out for changes in the money supply, there are a number of financial steps that make sense in any environment.

Recall from our discussion of human nature that our lizard brains tend to put too much weight on recent experience. Since Paul Volcker stopped inflation in 1979, the United States has experienced nearly perfect inflation rates. This suggests that most investors will be too little concerned with the possibility of either inflation or deflation. Having spent 20 years in a Goldilocks zone of low and stable inflation rates, we are likely to overlook the possibility of problems.

A funny thing happens to the stock of insurance companies after dis­asters. When a hurricane, fire, or earthquake hits, the insurance compa­nies pay claims that can add up to billions of dollars. What do you think happens to the stock price of these companies immediately after disaster strikes? You might expect the stock prices to decline to reflect the bil­lions of dollars in claims. Quite often, however, the result is exactly the opposite and the stocks rally.

Why do insurance company stocks rise on bad news? The answer is that people tend to buy insurance after big disasters. So the insurance firms are indeed hurt by the claims that they pay, but they also gain from the marketing of their product. Often the gains exceed the losses, and this can cause the stock price of insurance companies to go up after a disaster.

This response to disaster points out that in insurance, just as in other areas, most people tend to be exactly out of sync with the money-making strategy. The time to buy insurance is obviously before the event, when no one is buying and the insurance rates are low, not after the event when everyone is buying and rates are high.

Twenty years of Goldilocks has lulled most of us into exactly the wrong position. We have come to expect price stability. That means our lizard brains are likely to be underprepared for price instability, in the form of either inflation or deflation. To the extent that many of us are in the same position, now is the time to insure ourselves against price instability on favorable terms.

Here are three strategies to protect your wealth against both inflation and deflation. They are all ways to buy insurance in case we leave the Goldilocks world of low and stable inflation.

Buy at Today's Prices

The first technique is simply to buy at today's prices. If you buy the home that you plan to live in for some time, then you are protected against price swings. While you may suffer as compared to your alternatives, you will be safe within your home. Similarly, some states allow you to pay college tuition ahead of schedule.

If you buy the stocks of companies that own natural resources, then you are protected from commodity price changes. For example, if you own the stock of oil companies, then you will benefit from any subsequent rise in oil prices. If you buy the correct amount of such stocks, you can completely protect yourself from the effects of commodity price changes.

If You Borrow, Lock in Current Rates

Recall that high inflation is a jubilee where debts are effectively erased. The higher the inflation rate, the lower the true cost of repaying debt. In the 1920s, German debtors were able to pay off their mortgages with marks that were essentially worthless. Thus, high inflation provides a financial windfall to debtors.

This inflationary benefit to debtors is only true, however, for those with fixed-rate debt. A growing percentage of Americans are financing their debt with adjustable-rate loans. If inflation rises, these people will find that their payments have increased commensurately with the new inflation.

If you want to insure yourself against price changes, choose fixed rates for all of your debt. With fixed rates, your debts decrease in real value in inflationary environments. What about in deflationary times? In defla­tionary times, you can refinance your debts at lower rates.

So fixed-rate loans are better than variable-rate loans in inflationary times, and fixed-rate loans are no worse than variable-rate loans in defla­tionary times. Are fixed rates, therefore, a free lunch? The answer is they are not, because the fixed-rate loans are offered at higher rates than vari­able loans. The extra monthly payment for a fixed loan can be viewed as purchasing insurance against price changes. If the previous analysis is correct, then the world may be pricing such insurance at unusually low and attractive prices. Thus borrowing at a fixed rate may not be a free lunch, but it might represent a value meal.

Buy Inflation-Protected Securities

The U.S. government sells bonds that provide complete protection against inflation. The amount that these bonds pay is adjusted each year for the prevailing inflation rate. If inflation is high, the bonds pay more to reflect the lower value of each dollar.

Let's compare the payoff to an investment in a 10-year inflation-protected bond to an investment in a traditional bond without inflation protection. To be concrete, we will compare a $1,000 investment into U.S. government bonds with and without inflation protection. Both bonds pay interest over the years and then make a lump-sum payment at the end. Whereas a traditional, noninflation-protected bond simply returns $1,000, the inflation- protected bond adjusts the $ 1,000 based on the amount of inflation.

Thus, the inflation-protected bond returns at least $1,000, and perhaps more. How much more? That depends on the inflation rate. To see the specifics, Table 5.1 compares the final payment for the inflation- protected and the noninflation-protected bonds under four different inflation scenarios.

Scenario 1 is no inflation. Scenario 2 is a continuation of the Goldilocks environment of 3% inflation per year. Scenario 3 is a return to the late 1970s in the United States with 13% inflation per year. Just for fun, scenario 4 considers prices rising at 500% a year (although this inflation rate is high, it is far lower than the rate in Germany during the hyperinflation). So what do our bonds pay in these four scenarios?

Table 5.1 shows that when the original $ 1,000 is returned, the inflation- protected bond is always at least as good as the standard bond and usually much better. Even in extreme conditions, the inflation-protected bond ensures that the investor is protected.

This inflation protection, however, comes at a price. That price is the lower interest rate paid on the inflation-protected bond. Currently that difference is about 3% a year. Therefore the most that inflation insurance could cost you is about $30 a year for each $1,000 investment. This maximum price will be paid only if there is no inflation at all. If there is even modest inflation, however, the price of insurance is even less than $30 a year for each $1,000 investment.

Because inflation protection has been unnecessary over the last 20 years, the behavioral economic research suggests that our lizard brains, and consequently the market, may be undervaluing the inflation-protected bond. Furthermore, U.S. government bonds are fantastic investments in deflationary times. Therefore the inflation-protected bonds are almost unique in being great investments under both inflation and deflation. Thus, I believe that the inflation-protected bonds represent good value.

There are two types of U.S. government, inflation-protected bonds. They are the I-series of U.S. savings bonds, and the Treasury Inflation Protected Securities or "TIPS." There are some legal differences between the two types of bonds. For example, the savings bonds are restricted both in the amount of purchase and the type of investor (mainly U.S. cit­izens). Both bond types, however, are essentially identical when it comes to inflation anddeflation.

What about stocks as a protection against inflation or deflation? At first glance, this seems like a crazy suggestion. Consider three of the most famous periods of inflation and deflation. They are the current Japanese deflation, the U.S. deflation during the Great Depression, and the U.S. inflation of the 1970s. In all three periods, stocks were terrible investments. So stocks would appear to be a very bad way to protect wealth against an end-of-the-Goldilocks era of price stability.

While stocks were bad investments in past periods of price instability, they may be good investments now. Company profits have a built-in inflation protection, just like the U.S. government bonds. Inflation, without other economic change, simply inflates a company's revenue and costs. Thus company profit—the difference between revenue and cost— ought to rise in lockstep with inflation.

If corporate profits are inflation protected, why have stocks done poorly in previous periods of price instability? The answer may be that in those previous periods the inflation and deflation were symptoms of deeper problems. For example, the poor stock performance in the United States during the 1970s may not have been caused by inflation. Perhaps the oil shocks of the time caused both inflation and poor stock perfor­mance. Thus, in future periods of price instability, stocks may provide protection.