The past week or so has been a study in financial contrasts -- and since those contrasts involve home prices and whether they will rise or fall it may be useful to sort out what is being said and what the discussion might mean to all of us.

At the national level, the Federal Reserve is now worried about deflation. If you think 60 years of inflation has been unsettling, deflation is a true ogre, the type that would frighten even Shreck.

Inflation essentially means that buying power is reduced and you can't get as much for your cash. If $100 bought a new bicycle last year, with inflation it might cost $103 this year -- same bike, different price, because the value of money has declined. Inflation is one reason placing money under a mattress does not make sense.

With inflation you make money when the value of your assets increases faster than the rate of inflation. If the inflation rate is 3 percent and the value of your home increases 4 percent you now have additional spending power, real wealth.

Deflation is sticky and hard to cure. In the most extreme case, deflation is awful -- think of a depression. But even a mild deflation can be distressing.

To see a mild deflation at work, just look at Japan, a productive nation that has the world's second largest economy and has long-encouraged personal savings and thrift. But since 1989 Japan has been in an economic muddle with billions and maybe trillions of dollars in bad loans, reduced home values and declining stock prices.

What's odd about Japan is that deflation does not seem especially terrible. People have jobs, there is economic growth, and hoards of beggars are not roaming the streets. Toyota just reported an annual profit of $8.1 billion -- far more than any U.S. manufacturer.

But deflation is a problem. Potentially, it could mean that an asset bought at 100 might now sell for 80. That might be good news if you're a buyer, but not so good if you are a seller. It's surely not good news for many employees -- if widgets sold $8.50 and now go for $5.00, guess what will happen to the factory, the people who work there and the stores where employees buy?

To lend clarity to this matter, the Federal Reserve stated last week that during the next few quarters "the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level." In English, the Fed is worried about deflation.

It can be argued that the past three years have, in fact, been deflationary -- we now have the highest unemployment rate in 20 years, cars sales are shored-up with interest-free loans, the Euro is at it highest value against the dollar since 1999, goods at the mall seem curiously cheap, mortgage rates remain low and deficits are showing up at every level of government. And people are leery about the stock market, in part because recent disclosures are so damning.

Unlike Japan, in the U.S. we have had a powerful surge in home prices during the past few years. Can you have a general deflation and rising home prices? That seems unlikely and yet what have we seen since 2000?

What if home prices decline? Imagine a situation where a $300,000 home was bought with 20 percent financing. The initial mortgage balance is $240,000. Now imagine that in five years the property is worth $200,000 and jobs are hard to obtain. How can owners refinance or obtain a home equity loan? How do owners sell without taking cash from their pocket? Most likely, owners don't sell and the market stagnates with pent-up supply and few buyers.

No less important, if home prices weaken, the impact will be felt in every industry, trade and community. A poor real estate market, on top of rising unemployment, weak stock prices, and other negatives would create a worse economic situation than anything seen since World War II.

If we are entering an era with little inflation or actual deflation, can property prices rise? Can real estate flourish in such an environment? Instead of a housing decline, will there be an anti-bubble where home values actually increase even as the value of many other assets decline?

In Manhattan, as one example, there are arguments which favor higher prices.

According to Business360, a research organization, property values in Manhattan are likely to increase substantially during the next few years. How? As the company explains:

Analysis of key fundamentals suggests that the Manhattan mass-market is far from overvalued. Since the early 1980s, a time of high crime rates, near city bankruptcy, a 100-year population low and 16% mortgage rates, square foot prices have risen around 150%

Yet inflation has pushed prices generally up 130%, personal income has jumped 330%, the population is nearly 8% higher and mortgage rates are at multi-decade lows. Had real-estate values merely tracked the rise in personal income they would be about double current levels

Using moderate projections of personal income growth over the next five years, and assuming a rise in interest rates of 2% points, we expect real estate prices to rise by about 50-100% by 2008, or 8.5%-15% per annum

Will property values in places other than Manhattan grow even in the face of deflation? In large measure that's a local question, something consumers and the real estate community need to evaluate with care.

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