Is deflation the bigger danger

A know a number of people who argue that we are in an interest rate bubble because the fed is pumping too much liquidity into the system. They fear that all this liquidity is finding its way into higher asset prices which via the wealth effect will spill their way into the rest of the economy driving up consumption and causing massive inflation. Some of them are attempting to hedge by diversifying into foreign assets and perhaps gold. The Economist points to a recent paper that suggests this analysis is way wrong. In particular, it says that the high debt levels people have reached in response to low interest rates are putting us at risk of “debt deflation.”

Certainly, debt deflation is a particularly malign economic beast, which emerges when people curb their spending in an effort to pay off their debts. Those very spending cuts cause prices to drop, and force up the real value of debts, creating a vicious spiral. As the experience of America in the 1930s and Japan in the 1990s shows, central banks can do little about this, because they cannot set interest rates lower than zero. It was fears of just this sort that caused the Fed to slash interest rates 13 times, to anorexic dimensions.
[…]
Mr. King […] argues that the Fed was wrong to cut interest rates so much, because much of the deflationary pressure was of an altogether more benign sort: a reduction in overall prices caused by rapid technological change, improvements in the terms of trade and other factors.
[…]
Technological change and the integration of China, and increasingly India, into the global economy have pushed down the price of traded goods in America, thus pushing up real incomes. “And, because of these real gains, any rise in real debt levels will not be a source of potential ongoing instability,” writes Mr King. Alas, because the Fed’s perceptions of deflation have been coloured by the experiences of America in the Depression and Japan in its lost decade, it reacted by reducing interest rates sharply, a response that is more likely to bring about the debt deflation it most feared.
[…]
High real growth—so long as deflation is of the good sort—requires high real interest rates. If rates are too low, people borrow too much and spend it badly: what Mr King calls “happy investment rather than good investment”. For a given level of nominal interest rates, a fall in prices will deliver the appropriate level of real interest rates. But by cutting nominal rates to prevent deflation, the Fed has reduced the real rate of interest too much.
[…]
The low cost of capital has, moreover, encouraged speculation in risky assets, such as emerging markets, or—closer to home, as it were—property. And, yes, with all that money sloshing about, it has also pushed up inflation a bit.

So perhaps the question is whether policy makers will opt for higher inflation or risk debt deflation. Anyone know how to straddle inflation/deflation risk?

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