While many remain concerned that major inflation is lurking around the corner, GMO’s Jeremy Grantham says deflation, not inflation, is the greater concern.

“Even if we get intermittently rising commodity prices, which seems quite likely, the downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor,” Grantham writes in his latest quarterly letter. “With weak loan supply and fairly weak loan demand, the velocity of money has slowed, and inflation seems a distant prospect. Suddenly (for me), it is fairly clear that a weak economy and declining or flat prices are the prospect for the immediate future.”

Grantham notes that he had expected a strong bounce-back recovery to be followed by “seven lean years”, but he adds that he hadn’t expected things to slow down as quickly as they have in recent weeks. And, he says the push for fiscal tightening in Europe — and the U.S. — could make things worse. “You don’t have to be a passionate follower of Keynes to realize that to rapidly reduce deficits at this point is at least to flirt with a severe economic decline,” he writes.

The current market, Grantham says, is characterized by a tug-of-war of sorts between institutional investors and individual investors. It “might well be called a fearful, speculative market,” he says. “Low rates, although they tend to produce a feeding frenzy at the aggressive end of institutional investors, merely produce a feeling in ordinary individual investors somewhere between dejection and desperation. They hate to park money in cash at negative real returns, and yet they are still thoroughly nervous, so surveys reveal, about normal equity investing. These investors did not need the recent slowing in growth and sovereign debt problems to become nervous.”

In large part because interest rates remain incredibly low, Grantham says the speculative push has actually led small stocks and low-quality stocks to outperform this year — despite both categories being overpriced compared to higher-quality blue chips at the start of the year. He continues to think high-quality U.S. blue chips remain remarkably undervalued, and thinks that they present investors with some very good opportunities right now.

Grantham also offers some intriguing thoughts on the “bloated” financial system, the impact an aging population will have on the U.S., and even global warming. The full letter is available on GMO’s web site.