The battle between inflation and deflation is the most important thing for investors to watch right now, says Adam Lass. Fears of falling prices are rife in Washington today. But the inflation cycle will come around again soon, especially with all the new money being pumped into the economy by the Fed. Adam says that’s why investors should buy the PowerShares DB US Dollar Index Bearish ETF (NYSE:UDN).

This from Taipan Daily:

The most important thing for you to take away from the tail end of 2008 – indeed most all of 2008 – isn’t the real estate collapse, or the bank collapse, or the Wall Street collapse or the automakers collapse.

I’ll grant that this is one awfully big bunch of awfully big collapses. But in the end, they are all mere phenomena – not causes but effects, stemming of a fundamental battle.

I am speaking of the whole inflation/deflation thing. As we have pointed out repeatedly in this column, this interplay is one of the single binding actors in the market.

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Four Clues to Our Future

Right now, for instance, I have on my desk four articles from the feed services, and one chart. One bemoans the fate of retail stores who have been doling out 75% discounts since Black Friday in a desperate attempt to clear out rotting inventory and maintain at least a modicum of cash flow.

Now it appears that they are hoist with their own petard (the Shakespearean equivalent of shooting off your own foot), as shoppers seem unwilling to purchase a damn thing at retail anymore. (I can confirm this trend from personal experience: My wife actually made me wait till the 27th for my gifts so that she could get even better price breaks.

The second item is on the price battle brewing in airfares. The airlines have been cutting flights willy-nilly in an attempt to reduce excess capacity, and they still can’t seem to put bottoms in every seat. So now they will try cutting prices so low it will entice even the most reticent stay-at-homes back into the friendly skies.

Here too, I can confirm this trend from personal experience that our clan abandoned its usual holiday confab in NYC in favor of a long, long (really too long) retreat at Chez Lass. I must say that I did consider FedExing the children somewhere.

Anywhere really. Fairbanks, Alaska, came to mind.

The third item also confirms our reticence to spend or travel. It is from a data conglomerator, and notes that between November 2007 and October 2008, Americans drove 100 billion fewer miles than they did in the prior 12-month period. The report lays that drop at the feet of $140 oil.

Like a Snake Eating Its Tail…

This brings to mind the cyclic nature of these inflation/deflation trends. Allow me to demonstrate…

For the better part of a decade, I have warned that loose dollars would lead to spiking inflation, which in turn would stymie the very growth that those dollars were intended to stimulate.

And indeed this is exactly what came to pass. The price of most everything (other than lead-covered Chinese toys) shot to the moon, breaking the back of the American consumer and engendering the global recession we are now “enjoying.”

Inflation Begets Deflation…

But now that this recession has finally come to pass, the wags in Washington claim that deflation is now the number-one threat. And they point to those very items that I mentioned earlier: falling prices for oil, retail items and services over the past eight to twelve weeks or so.

As this trend continues, manufacturing falls off (and indeed it is at decadal lows now), and excess inventory begins to evaporate. The service sector curtails offerings (just as we see the airlines doing). And as the folks in the oil patch stop pumping expensive steam into old wells, or even stop searching out new ones, gradually we see all that excess oil disappearing off the market.

And in point of fact, most all of my wire service feed today is obsessed with the big fight between Russia and its former satellites. Seems that the demand for natural gas had fallen a tad, and now the Russians can’t get their asking price anymore. With the Russian stock market tanking, Putin and his puppets decided to cut the entire flow of gas to most all of Europe. “Don’t want our gas at our price, eh? Well, let’s seem ’em do without it, then.”

Everyone is calling this a political power play, and perhaps it is. But in the end, the Russians are simply doing exactly what the American airlines are doing: withdrawing excess supply.

… And Deflation Returns the Favor

Some look at this whole operation like a scale: Diminishing demand is balanced by diminished supply. But that would suppose that economies are simple systems that seek balance.

This is nonsense, and it’s a good thing too. In a genuinely balanced system, all information is uniformly distributed and understood, and all goods, services – and stock shares – are perfectly priced.

Real life, however, is a chaotic system in which a moron flapping his arms at a Starbucks on the New Jersey Turnpike can eventually raise the price of sugar in Brazil.

This system may seek balance, but it will never attain it. Rather, each cycle sows the seeds of the next imbalance. Again let’s look to oil: Already this reticence to look for new supplies has New York futures traders salivating like maddened dogs. Over the past few weeks, oil futures have risen some 43% off their December lows.

This brings me the final feed item on my desk today: It is from one of those speculators, noting that he anticipates that the demand will cross over available supply sometime in the next six to 18 months.

I’ll grant that this is an absurdly vague window. But it is his conclusion that is intriguing: He anticipates another whole round of massive oil price shocks. Except this time, it won’t stop at $140/barrel. He is figuring more like $240.

Is he nuts?

The Inflationary Power of $1.75 Trillion New Dollars

For that to happen we would need billions of dollars chasing relatively few gallons of oil. We already know how the oil supply is being reduced. Now where would we come up with, oh, say, $1.75 trillion dollars…

Oh my: That’s exactly the amount of money Washington has already put out there or is proposing to print.

And what happens when too much money chases too few goods? That would be called looming inflation, folks. Which is exactly why both Justice and I have been advising that you short the dollars any way you can now, while they are still big enough to short.

Specifically, I have and will continue to recommend both shares of PowerShares DB US Dollar Index Bearish (NYSE:UDN) for investors, and call contracts against the same for traders. The former ought to gain a minimum of 20% per quarter over the next twelve months, while the latter could earn deft operators 100% or more over the next 90 days.

Deflation or Inflation? Get It Right, and You’re Rich. Get It Wrong…