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Investors in the current economic environment are plagued by the quandary of whether we are entering an inflationary or deflationary situation. This question has been asked and answered in a variety of ways with no set conclusion, causing many to stay on the sidelines.

In a semiannual report on the economy to the U.S. Congress, Federal Reserve Chief Bernanke downplayed concerns the U.S. central bank's aggressive monetary easing could end up fueling inflation, saying he was confident the Fed could pull back its stimulus when the time was right. Bernanke's comments eased some fears of an inflationary environment, as a large supply of money added to the market would put pressure on the dollar, which causes inflation. If the Fed pulls back on money supply, the dollar strengthens. Unless the economy sees massive growth, this scenario would feed into a deflationary environment.

Some analysts and market participants had been comparing the current environment to the 1970s, but Bernanke said that is not the case. He said that until the recent slowdown, which he pointed out is due more to the result of conditions in the residential housing market and in financial markets than of higher oil prices, economic growth was solid and unemployment remained low. This was not the case following oil price increases in the '70s. He believes that from the perspective of monetary policy, just as important as the behavior of actual inflation is what households and businesses expect to happen to inflation in the future, particularly over the long term.

The Role of Oil and the Dollar

Prices of commodities usually rise when inflation is accelerating, so investing in commodities in the form of futures can assist in hedging the effects of inflation and deflation. Few assets benefit from the two environments, but commodities often do. As demand for goods and services increases, the price of goods and services usually rises too, as does the price of the commodities used to produce those goods and services. If the decline in the demand in a deflationary recession is met with a larger decline in supply, commodity prices may increase. Commodities acquire gains fast in periods of economic expansion, especially in the early stages.

Analysts say that when there is positive inflation and the global economy (total demand and output) grows, so does oil consumption. When deflation occurs and the global economy shrinks, so does oil consumption.

At present, the U.S. is not dealing with the effects of an oil embargo such as in the 1970s, but it is facing a situation of inflated crude oil prices, coupled with high demand from additional lesser-developed countries. Crude oil prices could see a big jump again, based on demand from countries such as China and India and the halting of refinery expansions, pipeline improvements and offshore-drilling projects due to the recession. As an example, from the lows in 2003 to the highs in July 2008, crude increased five times to a front month high of 14686. Since the peak, crude has sold off to a 2009 low of 4428.

The impact of tightening oil supplies and high energy prices on global economies will depend on whether the recession lingers for some years or starts to ease as early as 2010. With the plethora of information and varying opinions and estimates floating about, it is difficult to pin down the economic environment to which we are heading.

Bernanke said if people expect an increase in inflation to be temporary and do not build it into their longer-term plans for setting wages and prices, then any inflation created by a shock to oil prices will tend to fade relatively quickly.

The breakout in the dollar index could correspond to a breakdown in the crude oil market. A strong dollar and plentiful crude oil supplies contribute to a deflationary environment. In other words, since a significant percentage of crude oil is traded in terms of dollars on the world market, the purchasing power of crude would increase as the dollar rallies. This is by definition a deflationary environment. Both crude oil and the dollar appear to be testing longer-term trends, with crude testing support and the dollar testing resistance.

To trade from this scenario, we recommend the following. There are many options to hedge potential deflationary or inflationary market moves. To discuss your market strategies and targets, please contact Donna Heidkamp.

Donna Heidkamp is a Senior Trading Advisor at RJO Futures. Her interest in the futures industry stems from strong family ties to production agriculture in Hereford, Texas. After completing a bachelor's degree in Agricultural Economics at Texas Tech University in 1995, Donna moved to Chicago to participate in the Chicago Mercantile Exchange Agricultural Broker Training Program. The program exposed her to all facets of the futures industry, enabling her to work with experienced floor traders and develop a strong understanding of the intricacies of trading in the futures markets.

Since completing the training program in 1995, Donna has continued to gain a well-rounded knowledge of the industry by working as an order clerk, trading desk manager, and broker for RJO Futures. In 2004, she started a branch office of RJO Futures to focus her efforts on helping clients meet their trading goals. By identifying client objectives, managing risk, and providing a carefully tailored service, Donna serves as a dedicated liaison on all trading floors to full-service, broker assist, and online clients. Donna's commentary can also be heard regularly on CNBC TV and Bloomberg.

In order to continue to better serve her customers in an ever-evolving and dynamic industry, she also completed a M.S. degree in Financial Markets and Trading from the Illinois Institute of Technology in May of 1999.

RJO Futures is the retail division of R.J. O'Brien, one of the oldest FCMs tracing its history back to 1914.

Get RJO Futures' Complimentary 2009 Sharpen Skills Guide!

This complimentary guide includes pitfalls to avoid, 5 tips to keep your trading skills razor sharp and a review of market order varieties.

Get your complimentary guide today!