The Great Inflation-Deflation Debate

We’re all used to worrying about inflation. It ranks among the greatest threats to long-term financial security. But inflation has been so low that, in some quarters, deflation is being whispered about as the concern du jour.

Deflation occurs so rarely that even the experts have to discuss it in theoretical terms because there is very little data for them to study. The last bout occurred during the Great Depression.¹ Nonetheless, given that the current inflation rate is quite low (core inflation grew just 0.9% during the 12 months ending in April, the mildest increase since January 1966), there’s a possibility that the U.S. economy could fall into a deflationary period.² For this reason, it’s a good idea to understand the risks and the potential benefits of deflation.

If you understand inflation, then you already have the background to understand deflation. Inflation is a sustained increase in prices. The root cause is frequently monetary policy, but it can also be caused when one or more core commodities needed to produce essential goods and services, such as food and energy, become expensive due to scarcity and drive up other prices.

Deflation is nearly the opposite. It is a sustained decrease in prices, usually during a period of slow or negative economic growth. Sellers lower their prices in response to weak demand, which causes their profits to fall. Eventually, the sellers need to find ways to offset their lost earnings, so they cut back on their own spending on goods, services, and wages, which may lead to job losses, factory closures, and falling incomes. This further depresses demand, causing sellers to lower their prices, and so on. This cycle can worsen if it persists because consumers who still have money to spend may grow fearful and rein in their own spending.

Deflation can be caused by a central bank’s (i.e., the U.S. Federal Reserve’s) monetary policy, especially through reductions in the availability of money or credit. It can also occur when spending falls dramatically in one sector of the economy. For example, if the government curtails spending, then the businesses, workers, and consumers who depended on that spending for their own incomes would no longer be able to maintain their own spending habits, thus creating hardships for the businesses and workers their incomes supported. If this loss of demand becomes widespread, a deflationary condition can occur.

Theoretically, the cure for deflation would be for the central bank to create inflation through a loosening of its monetary policy, by lowering interest rates and expanding the money supply. However, because of the Fed’s response to the 2008 financial crisis, monetary policy has seldom been looser, meaning the Federal Reserve may have limited means to battle a potential battle with deflation.

How Could Deflation Affect Investors?

Again, because deflation is uncommon, it’s difficult to be specific about how investors could be affected. In the simplest terms, deflation could discourage risk-taking in the stock market because of the expectation of low returns caused by falling corporate earnings. Investors might be tempted to keep their assets in cash. Deflation could also cause problems for bonds because it causes the purchasing power of money to rise, giving borrowers a disincentive because they would be repaying loans with money that was more valuable than what they borrowed. However, this scenario could benefit bondholders.

Maybe Not

Although some experts believe that deflation is on the horizon, there are several conditions that have economists and policymakers worried about the potential for higher inflation in the coming years.

• The ramp-up in government spending resulting from economic stimulus and emergency measures.
• Longer-term structural deficits caused by the government’s growing financial obligations associated with Social Security and Medicare, and the immense national debt that could result if these challenges are not addressed.
• The Federal Reserve’s injection of nearly $1 trillion into the banking system during the financial crisis. Although banks have kept much of it in reserve, many worry that prices will rise when credit eases and that money begins circulating.³

Nobody knows for certain the direction that prices will take in the near term. Ultimately, inflation and deflation are variables that you can’t control; therefore it is wise to adhere to a long-term investment plan that has been crafted to fit your personal situation and is positioned to withstand fluctuations in market conditions.

1) Thomson Reuters, 2010 (consumer price index for the period 3/31/1913 to 12/31/2010)
2) U.S. Bureau of Labor Statistics, 2010
3) Federal Reserve Bank of Minneapolis, 2008

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2010 Emerald.