The Challenges of Deflation
10/01/2010 - Paying less for groceries, gas and other items we buy every day sounds appealing on the face of it. That is why most of us look for bargains in the stores and online. But over time we've come to expect that in general, the cost of living increases. Now there is speculation by some economists that we could be entering into a different economic environment—one where deflation, rather than inflation, becomes a dominant theme.
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Is this a good thing? As consumers, we may believe so, but deflation tends to be a sign of more significant economic problems that may be harmful to workers, consumers and investors.
The damage of falling prices
Rising prices tend to be driven by increasing demand for goods and services. Many of us have experienced how prices can spike when demand is high and supplies are limited. You might recall, for example, feeling 'pain at the pump' during times of tightened oil supplies.
During good economic times, a modest level of inflation, in the 2% to 3% range each year, is considered very acceptable and probably even beneficial. It indicates that an economy is achieving a stable level of growth.
In a deflationary environment, prices are falling. This is typically due to a drop in demand. Consumers and businesses become cautious about spending, putting less money into the economy. This results in an over-supply of goods and services. The problem can feed on itself. If lower demand is pushing prices down, buyers may be encouraged to wait before making purchases in hopes that prices will drop even further. This can send an economy into a prolonged tailspin.
Companies that sell goods and services have a difficult time increasing revenue if prices are falling. Deflation can be a serious challenge to firms that are not used to coping with their prices going backwards. The most notable exception in our economy is the technology sector. Prices of computers and other new, innovative products tend to drop over time as production scales up and components used to create the product become more widely available. Despite falling prices, these companies tend to benefit because sales volume rises dramatically as prices decline.
The situation is not so favorable for other types of businesses that have more stable costs. An additional concern is the impact of holding debt during a time when prices are declining. The fixed costs of repaying debt become, in effect, more expensive if deflation lowers the value of the item purchased with the borrowed money.
The history of deflation
While deflation is rare, it is not new. The most notable period of deflation in the U.S. economy in recent times occurred during in the 1920s and 1930s, the years leading up to and starting the Great Depression. According to the Consumer Price Index—the primary barometer of the nation's inflation rate (provided by the U.S. Bureau of Labor Statistics)—the cost of living declined almost 27% over a six-year period (1926 to 1932). This also marked a time when the economy went from a boom to a bust, banks failed at a rapid rate and the unemployment rate reached 25%, seriously dampening consumer demand for goods and services.
A more recent example of a major economy suffering through an extended period of deflation is Japan. After stock and real estate prices rose dramatically in the 1980s, the economy shifted and prices dropped dramatically. Since that time, Japan's economy has been mired in a deflationary environment.
Financial implications for the individual
It is too early to say whether deflation will become a reality in our modern economy, but given that few investors have experienced it before, here are a few points you should keep in mind as you think about how to manage your money if it occurs:
#1 – Keep debt down
Even if interest rates are low, having to make fixed payments over an extended period of time at the same time that the item you borrowed money to purchase is losing value eats away at your wealth. Pay down existing debts as much as you can and be cautious about additional borrowing until the economy stabilizes.
#2 – Consider fixed income investments
If deflation persists, companies may be challenged to grow earnings. That would likely dampen prospects for stocks in the short term. By contrast, fixed income investments will look more attractive. Take, for example, an investment that offers a guaranteed fixed return of 4%. In an environment where the inflation rate is 3%, an investment earning a 4% return would have a real (after-inflation) return of just 1%. By contrast, if the inflation rate is -1% (deflation), the real return on a 4% yield is 5%. To the extent you can guarantee your return, you will be protected in a deflationary period.
#3 – Hang onto your cash
If goods and services are losing value, the cash you hold onto is, in effect, increasing in value. You should take your time in making large purchases (such as homes and cars) and watch the direction of prices. They may move in your favor. Keep in mind that in U.S. history, deflationary periods have tended to be temporary, and that rising prices are more common. Also note that delaying purchases means you also lose the value of owning and utilizing the item for an extended period of time. Weigh your options carefully.
It isn't clear yet whether actual or sustained deflation is in the offing. Unforeseen events can quickly change things – such as another spike in oil prices or bad weather that hurts crop production and drives food prices higher. As is always the case, investors need to be prepared for the uncertainty of the economy and markets.
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