Deflation 101

Posted by Jim Flanagan on Mar 03, 2016 16:00:00 PM

Topic: ALL

Business team having a meeting

While falling prices seem to be a positive indication of economic health, too much of a good thing may lead to  unpleasant results. With inflation rates below 0% deflation may become a valid concern. If deflation sets in, consumers  could develop the mindset of “putting off until tomorrow” certain discretionary spending because they may think the cost  will be less if they wait.  The result is a decrease in consumer spending, followed by many companies needing to reduce costs, which results in less revenue for businesses. The cycle continues to spiral from there.  

There has been buzz about deflation lately, as some economists are speculating that the U.S. economy could fall into this trap. The concern is based on the falling inflation rates over the past year, in large part driven from the notable decline in the price of oil. But while oil is getting a lot of the attention, there have been a number of additional factors at work as well, including but not limited to the following:  

Technology has led to great improvements in productivity resulting in lower costs and lower prices. Oil is a great example of this.

Aging population. As boomers age, there is a drop in their purchasing needs for homes, baby cribs, lawn movers, etc. drop. Demographically, the U.S. is seeing a shift in population, which is lowering the demand for many consumer purchases. Across the board, lower demand means lower prices.

Deleverage.  Many consumers and businesses witnessed the harsh realities of too much debt during the great recession, and overall have been more conservative in their use of debt, which results in postponed purchases.

Strong U.S dollar. The relative strength of the U.S. economy compared to the rest of world has been strengthening the dollar, which has helped to lower the cost of imported items here in the U.S.

In light of this information, what should we do?

Lower rates. The Fed’s first line of defense to fight deflation would be to lower interest rates.  Given how low they already are, it’s hard for them to get much lower, but it would be a good bet that we won’t see any of the anticipated increases.

Reduce debt. While rates would be low, high debt levels generally would not help if we experienced deflation.  For one, with a stressed economy, future incomes of both consumers and businesses are less predictable, so decreasing required loan payments would certainly seem prudent. Additionally, unlike inflationary times, the dollar becomes more valuable with deflation, so paying debt off early, with less valuable dollars would be easier than later, when the loan balances will be higher relative to the dollar’s increased purchasing power.

Investments in stocks should be done very carefully and preferably with a reputable investment advisor.  If the economy is not as strong, defensive stocks, which can perform well in a down economy, such as consumer staples, may do better, particularly if they pay a dividend, although stock appreciation would likely be limited.  Utilities, particularly regulated utilities, may be a good choice, as consumers will generally need these necessity items and the regulators should help ensure the utility is properly compensated to make a profit. It is always smart to have a strong investment advisor and wealth manager when making any investment decision.

While yield is always nice, with deflation, principal preservation may be a good strategy in itself, as purchasing power would be expected to grow over time due to falling prices.  While filling your mattress with cash is one alternative, a bank account could offer more convenience, and with the added security, and a softer mattress, a better night’s sleep.

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