The question facing every investor today, and the one that could wield a very large influence over one’s investment fortunes – is whether deflation or inflation will hold sway during the next couple of years.

To preview our conclusions: we’re betting on inflation.

So what is this thing called, “inflation?”

According to the 1962 edition of Webster’s New World Dictionary, inflation is “an increase in the amount of currency in circulation or a marked expansion of credit, resulting in a fall in the value of the currency and a sharp rise in prices.” That’s the classic definition

But for those of us who are not economists, theorists or ivory tower residents, inflation is simply the thing that turns a nickel Coke into a $2 Coke. And it is the thing that causes gold to rise from $32 an ounce to $1,000…on its way to a much higher number.

The classic definition of inflation – an increase in the supply of currency and/or credit – and the Main Street definition – rising prices – are different, but related. The first excess causes the second excess.

At this very moment, the supply of currency and credit is expanding at an alarming pace here in the U.S.A., and yet, the prices of goods and service are falling. So this curious condition has led many folks to speculate that deflationary forces will triumph over inflationary forces.

We are skeptical.

The U.S. Government has embarked on a massive monetary experiment – an experiment that is more sorcery than science. The Federal Reserve is in the process of conjuring up trillions of dollars from the cauldrons of the Treasury to help finance the government’s bailout campaigns.

No one knows, least of all Ben Bernanke or Timothy Geithner, if the Fed will conjure up one dollar too many. And no one knows if the Fed could ever coax its magical deflation-fighting dollars back into the cauldron, once their services were no longer needed.

At least, in theory, no one knows…

In reality, everyone knows: the excess dollars will never return to the cauldron. They will escape into the economy at large, where they will run rampant, and cause the price of eggs to increase to $10 a dozen…or $20…or maybe even $100.

The monetary sorcerers at the Fed – and at all the other central banks of the world – know everything about inciting inflation, but absolutely nothing about reigning it in. Furthermore, inflation is not exactly Public Enemy #1. Most of the world’s central banks are far more worried about deflation – so much so that they will openly admit to printing currency.

“Chancellor of the Exchequer Alistair Darling suggested the Bank of England could start printing money as soon as this week to help revive the economy,” Bloomberg News reports. “Bank of England policy makers sought permission from the Treasury to create money to buy securities…The bank should get authority to use as much as 200 billion pounds for purchases of government bonds and other assets…”

In times past, an announcement this brazen would have caused a panic selloff in the currency in question. But today, the announcement attracts scant attention. Think about it; the Bank of England declared to all the world that it would print $300 billion worth of currency, backed by nothing more than paper and ink, and that it would use this currency to buy government bonds. That’s shocking. And yet, no one seemed to care. The British pound barely moved in yesterday’s trading.

Deflation is the fear du jour. Not inflation.

The consensus prediction/expectation goes something like this: A powerful deflationary trend will overwhelm all inflationary impulses for a year or so. Then, a new inflationary trend will emerge, and it will likely develop into a 70s-style hyper-inflation. Inflation might become a problem in 2011 or 2012. But not now.

Therefore, says this anonymous consensus, the smart money should have nothing to do with inflation hedges like gold, commodities or TIPs. Instead, the smart money should be gobbling up DE-flation hedges like long-dated Treasury bonds.

This tidy consensus might be dead on the mark…or it might already be dead in the water.

For example, what if inflation arrives much sooner than expected? What if the widely anticipated deflation never materializes? The holders of long-dated Treasurys would fare very, very poorly. And the non-buyers of gold would be very chagrined, at best. So consider this two-part question:

1) Is the 2.89% yield of a 10-year Treasury so thoroughly compelling that it justifies risking an enormous capital loss, (if inflation appears sooner than expected)?

2) Are commodity plays at their current depressed quotes so thoroughly risky investors should continue to shun them, no matter the price?

Certainly, the reasoning behind the “theory of imminent deflation” relies upon the intuitive and unassailable logic that recessions tend to suppress demand and, therefore, prices. Furthermore, depressions tend to suppress demand and prices even more than recessions.

This logic enjoys some noteworthy historical precedents, like the Great Depression. And it is certainly true that slowing economic activity tends to suppress demand. But this argument ignores the supply side of the deflation equation – not just the supply of goods and services, but the supply of money as well.

Depressions do not merely suppress demand; they can also restrict supplies of essential commodities and goods. As the producers of these products struggle with access to credit and with falling prices for their goods, some producers reduce production or go out of business entirely – a factor that contributes to rising prices, all else being equal.

Furthermore, in some macroeconomic settings, the money supply can wield an even greater influence over price trends than the supply of goods and services. In some unfortunate corners of the globe, for example, where desperate governments have printed one too many pesos, bolivars, rupees, marks or rubles, the inflation rate has skyrocketed, even while inflation remains stable in other corners of the globe.

In Zimbabwe, the infamous issuer of the world’s first billion-dollar note, inflation has been raging for years. But prices have remained relatively stable in all the developing economies. More recently, while the entire Western World trembles about the onset of deflation, prices (in local currency terms) for basic staples are soaring in Russia, Mexico, Latvia, Poland, Iceland, Korea and many other places.

If falling demand, alone, caused deflation, why are so many dramatic inflationary episodes sprouting up around the globe?

These recent inflationary episodes in the developing world are sending an unmistakable signal to those of us in the developed world that the difference between inflation and deflation lives on a razor’s edge – or perhaps, on a printing press’ edge.

Let’s review:

1) Deflation seems like a legitimate threat at the moment.

2) So the Fed is fighting this threat with an unprecedented expansion of its balance sheet – i.e. money-printing campaign.

3) Money printing tends to cause the rise in goods and services that we ordinary folks call, “inflation.”

4) The timing and magnitude of a new inflationary trend is unknowable, even though it is extremely likely to occur.

5) Therefore, buy gold. Oops…we did not get to that part yet.

But we’re out of time to day. So check in tomorrow as we take a peek at a few specific inflation plays.

Source: Monetary Sorcery