As consumers, we have entered a very difficult period in our lives now that many emerging markets are growing up and gaining first-world status. The wave of humanity entering the middle class has created exponential demand for a better way of life that has put huge upside pressure on prices for just about every good and service we use.

When China entered the World Trade Organization in 2001, it was the sea change that kick-started this whole commodity boom that until just recently showed a steady and relentless uptrend for food and energy prices, two of the most important components of any household budget. Price spikes in either of these categories for any extended period of time ignites the fires of inflation that can rapidly stifle the economy.

The danger for higher oil prices is that it feeds down through the supply chain into businesses. Everything that requires a transport to get a good or a service to market is going to feel the need to pass that cost on to consumers. And it is that aspect of higher oil prices that will be of the concern for inflationary pressure going forward. Fortunately, oil prices have settled down, trading below $80 per barrel for the time being, with the national average for a gallon of gasoline at around $2.65 per gallon.

We’ve also seen grain prices soar in recent months due to drought conditions in major global farm belts, which in turn will soon be felt when paying the tab at restaurants and the local grocery store in the form of higher retail prices.

Catastrophe can also be a major catalyst for inflation to rear its ugly head. Following the severe floods in Karachi, Pakistan, analysts revised the Consumer Price Index (CPI) inflation outlook there to 15% on a yearly basis for fiscal 2010-11, given the existing food and supply-side inflationary pressures. Food price increases are the main culprit behind the rapid inflation in Pakistan, as food inflation increased by 15% on a yearly basis in August, owing to a far-greater spike witnessed in perishable food items of 41% annually.

But no one can predict when a natural disaster of biblical proportions, like this one, will strike.

Inflation, the Fed and Your Money

Do you remember when President Richard Nixon imposed emergency wage and price controls on the economy? He took this extraordinary measure because inflation was seen as a national crisis in the summer of 1971 as prices for everything consumers bought were spinning out of control.

You have to keep tabs on those measures that are closely correlated to inflation because they react to current conditions on a daily basis and reflect the true big picture for inflation. One such measure is the value of the U.S. dollar on foreign-exchange markets. Throughout history, when the dollar falls, it’s a precursor of inflation to come.

Currently, the dollar has fallen 45% over the last eight years. From the chart below, it’s easy to see the correlation between the steep decline in the value of the dollar from 2002 to late 2007, right when the real estate and stock markets topped out. The subsequent spike in the greenback during 2008 and into early 2009 reflects deflationary pressure from the recession and has since failed to take out the 2009 high of 90, indicating another retest of the lows is more probable at this point.

At present, the Fed has to keep interest rates artificially low and maintain a monetary policy of quantitative easing in order to pump life back into the ailing credit and housing markets, but it is a dangerous game to play given the rising tide of costs. The bond market has been stable with historically low interest rates persisting throughout this uptrend for the commodities.

However, throughout most of the 1970s, when inflation was turning into hyperinflation, 10-year Treasury bond yields never correctly anticipated the inflation to come. (Sound familiar?) Today the yield on the 10-year Treasury note is a paltry 2.74%. Toss in core inflation of 1.3%, and investors are getting paid less than 1.5% yield for taking 10 years of risk. This is the contention of those calling today’s bond market a “bubble.”

The net effect of all this freshly minted money could be rampant inflation, in which the dollar loses substantial value against other currencies and yields on Treasury bonds spike higher. During the past two months, that premise is taking a firm hold in the gold and silver trading pits as spot prices are gapping higher with each and every failed rally attempt in the dollar. The macro-inflation genie is now out of the proverbial bottle, and it’s still early in this worrisome scenario.

Some Say, “It’s Deflation, Stupid”

Those in the deflationary camp would argue that bouts of inflation in nations like Pakistan don’t factor into the big picture. Economies from the United States, Japan and much of Western Europe that comprise more than half the world’s GDP are experiencing protracted deflationary pressures in the wake of higher energy and food prices. These three economies are consumer-dependent, unlike China and Brazil, which are more export-dependent. Consumer spending has been, and will continue to be, soft.

U.S. growth slowed during the summer, but the economy was still expanding at a “moderate” pace, according to the Federal Reserve’s latest report on the economy. The Fed survey, commonly known as the Beige Book, dovetails with a slew of data that shows the U.S. recovery has tapered off since the spring. Yet despite recent weakness, the report also indicates the economy is still growing.

According to the Beige Book, “Economic growth at a modest pace was the most common characterization of overall conditions.” What’s more, the Fed report noted that the price of wages and goods and services remained “limited,” indicating little inflationary pressure in the economy.

ChangeWave Research’s latest corporate quarterly survey shows a sharp pullback in the U.S. economic recovery, led by a downturn in third-quarter sales projections and weakness across a range of key indicators — including capital spending, the job market and the fourth-quarter sales pipeline. The road coming out of a recession can be a bumpy ride, as we saw after the 2001 downturn. The current survey points to a tough second half of the year for the U.S. economy, but 2011 may see GDP growth reaccelerate.

Deflationists would argue strongly that the structural damage done to the housing and labor markets by the subprime-induced recession will take years to come out of, similar to that of Japan’s lost generation of growth. We’ve already experienced the lost decade of stock market returns, or lack thereof. What’s to say another 10 years of destruction of investor capital isn’t in the cards? Especially when the percentage of GDP to pay interest on the Federal debt is expected to double over the next couple of generations.

The total debt has increased more than $500 billion each year since fiscal 2003, with increases of $1 trillion in FY 2008 and $1.9 trillion in FY 2009. And it only gets worse as laid out by the nonpartisan Congressional Budget Office. From the chart below it is clear the U.S. economy is facing a period with a ballooning and untenable debt load unless radical spending cuts are brought to bear on government budgets.

 CHARTS GO HERE

Even before the economic crisis, the U.S. debt ballooned 50% between 2000 and 2007, growing from $6 trillion to $9 trillion. The $700 billion bailout helped the debt grow to $10.5 trillion by December 2008. Total economic output as of Q1 2010 is $14.6 trillion. That means the debt is now 89% of GDP, up from 51% in 1988.

Sound ominous? It should.

The Worst of Both Worlds

At some point, the economy reaches the point of no return … kind of like a lot of the unemployed who qualified for modified home loans under the federal stimulus plan. (This program only delayed — not prevented — the eventual demise for many homeowners.) It’s at this point that protracted stagflation sets in, bringing a period of spiking interest rates, higher prices and negative growth — essentially the worst of all possible scenarios that drives the economy into a depression.

So the “tug of war” between the hyper-inflationist camp and the doomsday deflationists wages on. My view is we have serious elements of both inflationary and deflationary components in place and both forces ultimately lead to the same bad ending for the economy — it contracts big time.

On the one hand, spiraling deficits feed interest rate inflation and food shortages, and oil spills feed commodity inflation. On the other hand, persistently high unemployment, rising foreclosure rates and a slowdown in forecasted capital spending only leads one to fear of the economy slipping back into a recession, where prices for goods and services crumble and real estate rolls over after such a fragile rebound.

Adding to the angst, the gold and silver markets are telegraphing further deterioration in not just the dollar, but most major world currencies as sovereign debt ratios rise. The trajectory for gold portends of nasty cycle ahead where the dollar completely breaks down against other major currencies aside from the euro.

At present, the balance of inflation versus deflation is favorable to both stocks and bonds, and plays right into the soft-landing scenario for emerging markets and the slow recovery for developed markets. This fully explains why indexes from Indonesia, Malaysia and Chile are hitting all-time highs, and U.S., European and Japanese markets are rallying off their August lows. The backdrop for inflation/deflation appears non-threatening, prompting money to put risk back on the table by owning equities.