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Economic Forecasts

How to Profit in Today's Economy: Hedge Your Bets on Prices

Spread your money among these investments to protect against inflation or deflation.

What it's all about. Prices in the U.S. are as stable as the Rock of Gibraltar -- for now. Kiplinger's expects inflation to wind up at less than 1% in 2010. A little inflation is a good thing, but today's seemingly placid prices are the product of a half-dozen powerful and competing forces. If they're not carefully managed, they could have dire consequences -- years of high inflation or even deflation, a rare situation in which prices actually decline.

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How it's different this time. Since 1926, the consumer price index has increased by an average of 3.0% per year. So the current inflation rate is a bit too close to deflation for the comfort of many economists. Most experts see three possible outcomes.

The good: The economy slowly improves, keeping deflation at bay and giving the Federal Reserve Board a window of opportunity to siphon off all the extra cash it has injected into the U.S. economy before inflation takes off. This outcome is probable, not certain.

The bad: The economy revives, the Fed doesn't act quickly enough to reverse all of its stimulative actions and inflation shoots up. There's no inflation on the horizon for at least two years, but the odds of this are significant.

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The ugly: Prices fall. Deflation halts the economy in its tracks as people stop spending, waiting for prices to drop even further. The chance of deflation is low.

How you can profit. In this environment, it pays to play defense. If deflation takes root, you'll want to hold plenty of cash and income-producing investments because their value increases as prices drop. Invest in high-quality bond funds, such as Harbor Bond (symbol HABDX) and Fidelity Intermediate Municipal Income (FLTMX). Prudence suggests avoiding long-term bonds, which would get slammed if inflation heats up. Assets that do particularly well when prices take off are inflation-adjusted bonds, floating-rate loans, commodities and real estate. Fidelity Strategic Real Return (FSRRX) holds all of those groups.

Don't discount stocks as inflation hedges. They generally fall in value when inflation rises, but they come out ahead over time.

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