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Opinion is divided about where the economy goes from here. The Guardian Money team offers suggestions on what to do for either case
• If you think inflation is on the way …
Savings
Buy National Savings index-linked savings certificates
Nest eggs were destroyed in the 1970s when inflation rocketed to 25%. About the only simple way to inflation-proof your savings is National Savings & Investments' index-linked savings certificates. These government-backed products pay a return linked to the retail prices index (RPI). You can choose three- or five-year certificates which pay RPI plus an average of 1% tax free – good news for higher-rate taxpayers.
If you put £100 in today, and RPI remains at 3% over the term, you would get £112.35 after three years. If you believe the government's cash printing presses will spark an inflation surge, take the five-year bonds and enjoy the ride. If RPI rises to 10%, you'll get close to 11% per year, tax free. You can invest between £100 and £15,000 in each certificate.
Mortgages
Buy A five-year fixed rate at 3.99%, or a 15-year fix at 5.94%
High inflation often spells high interest rates, so borrowers may want to lock into ultra-low rates with a longer-term fix. Britannia building society has a 15-year fix which allows you to jump ship every three years. The flexibility is appealing but not the rates – the best on this deal is 5.94% and, for that, you need a 40% deposit.
David Hollingworth at London & Country believes three- to five-year fixed rates will grow in popularity. One of the best deals is HSBC's five-year fix at 3.99%, but a 40%-plus deposit is required. Woolwich has a four-year fix with the same rate (also 60% maximum LTV; purchase only). "The upside of higher inflation is that it erodes debt quicker," says Hollingworth. But that doesn't mean you should super-size your borrowing for the sake of it.
Investments
Buy Gold, property, index-linked gilts, emerging markets
Anyone who took out a mortgage in the inflationary 1970s saw it shrivel to a tiny real sum by the mid-1990s. So is investing in property long term the way to protect yourself? Now prices have fallen it's tempting. But (a) banks are not lending much and (b) you'll have the short-term pain of high interest costs when the Bank of England raises rates to combat rising prices.
Investment folklore suggests the only way to truly protect yourself against inflation is by buying gold. It leaped from below $150 an ounce in 1976 to $750 in the early 1980s, then began a long decline until the start of this decade. Oddly enough, it has reacted little to the economic gloom encircling the globe since 2007. Swiss bank UBS says gold could hit $2,500 within five years. It used to be an esoteric market for the rich, but buying gold today is much easier through an exchange-traded fund from £50.
Equities are seen as a long-term hedge against inflation, but investment adviser Mark Dampier of Hargreaves Lansdown warns against expecting them to offer much short or medium-term protection. "If you have inflation, no asset class likes the transitionary period. It's painful for everything, as it means interest rates have to go up." Over the shorter term, he says index-linked gilts – government bonds that shield investors from inflation – may offer more protection. You can buy these from the government's Debt Management Office, from £1,000.
The other opportunity is to look east. The bullish are pointing to the 30% rise in the Shanghai composite index this year. The way in is via a global emerging markets fund; top trusts include funds from First State, Baring, Aberdeen, JP Morgan and Templeton.
Pensions
Buy Index-linked products
Pensioners lose most from inflation. It hits the real value of savings, while pensions fail to keep up with prices. You can try to protect savings with National Savings index-linked certificates. You can also buy a degree of inflation protection for your pension annuity. But it's expensive. For example, a couple both aged 65 with £100,000 savings will be offered a fixed annual income of £6,818 from the current best provider, according to the Annuity Bureau. If they want their income to go up in line with RPI, they will be offered an initial annual £4,115.
Pensions analyst Laith Khalaf of Hargreaves Lansdown says: "Investors should inflation-proof some pension income; splitting a pension between a level annuity, a 3%-escalating annuity and an RPI-linked annuity is one way. Drawdown is a solution for those with larger pots. Whatever they do they shouldn't ignore the inflation risk."
If you are younger and just starting to save in a pension, inflation is less of a worry. It will be invested in a range of equities that should, over the very long term, at least rise in line with prices.
• If you think deflation is on the way …
Savings
Buy Nationwide five-year bonds, 4.15%
If you believe the UK economy is set for Japanese-style long-term deflation, locking away savings in fixed-rate bonds is the way to go. Nationwide offers a fixed 4.15% return on its five-year bonds, a good rate in the current climate but which might prove a fabulous one. If inflation falls to -3% and stays there for several years, the decision to save at such a rate would fall into a "greatest financial decisions" category. However, if you believe we are due a shorter period of deflation, and a big jump in interest rates when inflation returns, a different strategy is required.
ICICI Bank will let you lock away your money for one year at 3.9% or two years at 4.1%. The India-owned bank is 100% protected by the UK's financial compensation scheme up to £50,000. If you have a minimum £10,000 cash, Close Brothers this week launched a two-year, fixed-rate bond paying 4.3%.
Anyone riding out two years of falling prices, and the zero interest rates that would surely follow, would be very happy as their savings earned more than 4% – particularly if rates start rising quickly from 2011, allowing them to then jump ship and redeploy their significantly enhanced reserves.
Mortgages
Buy First Direct tracker, at 2.39% above Bank of England base rate
If deflation takes hold, interest rates will probably remain ultra low, so you don't want to fix at a high rate. Instead, those looking for a new home loan might want a deal that tracks the Bank of England base rate.
First Direct has one of the best tracker mortgages on the market at 2.39% above Bank of England base rate for life, giving a current pay rate of 2.89%. But, as London & Country's David Hollingworth points out, while that might look like a brilliant rate right now it's not going to look so good if the base rate is 5%. That deal's pay rate would be 7.39%.
Investments
Buy M&G Gilt and Fixed Interest, Allianz Pimco Gilt Yield
The winners from deflation will be government bonds, assuming the government does not default on payments, or the bonds of top-quality, recession-proof companies. These pay a set interest, which will be worth more at a time when prices are falling. You can buy gilts direct or through a fund, such as Allianz Pimco Gilt Yield (up 14.5% over the past year) or M&G Gilt and Fixed Interest (up 11%).
Investment adviser David Kauders of Kauders Portfolio Management has for years warned about an impending bear market, and believes it has far to go. Capital destruction in stock markets, falling house prices and job losses will knock inflation on the head, and the only place to preserve your capital is in gilts, he says.
"The world has changed. Yet most economic advice, and financial and investment advice, assumes inflation is here for ever. Everyone needs to accept that deflation matters more than inflation. If you plan for deflation, you won't be caught out. Deflation makes fixed-income more valuable. If you plan, instead, for inflation, you will be disappointed. Only gilts do well in a deflationary environment," he adds.
Property won't bail you out. Huge mortgages will remain a growing burden on those who took them out, particularly as companies impose pay freezes. Meanwhile, prospective buyers will defer purchases in anticipation of lower prices, which will in itself hasten the deflationary spiral.
Pensions
Buy State pension, AVCs
Pensioners dependent on state handouts could be the unlikely winners from deflation. State pensions change at the start of each tax year on 6 April, and the increase is based on the RPI the previous September. Last year, that was at a relatively high 5% rather than this week's zero rate. So the basic state pension will rise from £90.70 to £95.25 for a single person.
Even if deflation continues, and prices start falling year in, year out, pensioners are protected. The government is committed to increasing the state pension by RPI or 2.5% a year, whichever is higher. So if prices remain static over the coming year, and most workers suffer pay freezes or pay cuts, pensioners will enjoy an increase in the basic state pension from £95.25 to around £97.65 in 2010.
But those who took inflation-linked annuities could find their income falling if inflation turns negative. Annuities from Prudential and Standard Life could fall, while those from Norwich Union and L&G will not decrease, but then will not rise until RPI has reached its previous level. AXA policies are under review.
Many people with final-salary pensions are protected from deflation. Most schemes were set up in the days when inflation was common and offer annual minimum increases in benefits, often 3%, regardless of RPI.
But for younger workers saving into a pension, deflation is likely to be bad news. It tends to hurt equities, in which pensions are invested. Not only might workers suffer pay cuts, they may also be asked to pay more into their pension via additional voluntary contributions (AVCs) - with no guarantees as to how much they will pay out.
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