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Deflation can vex investors

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By Tom Pappenfus

Cautionary headlines of deflation have followed official reports of falling prices.

The opposite of inflation, deflation is the decline in prices of goods. We don’t hear as much about deflation because it is rare. The last time it affected the U.S. to any great extent was during the Great Depression. It has affected other countries more recently.

A recent dip in the Consumer Price Index heightened talk of deflation. The broadest official measure of the cost of living, the CPI dropped for the third month in a row in January. More notably, year-to-year, the index turned negative for the first time since October 2009.

But don’t get nervous. The index bounced back again in February, and if you strip out the volatile costs for food and fuel, we continue to see inflation. Deflation is not a credible threat in the U.S., although it remains an issue in Europe and Japan, so it is worthwhile to examine.

Prices going down, on the surface, sounds good: Our dollars go further as goods become relatively cheaper. But that’s not the whole story.

How rare is a decline in prices?
Bureau of Labor Statistics data after World War II show these as the only incidents of 12-month declines in the Consumer Price Index:

  • Jan. 2015
  • March – Oct. 2009 (8 months)
  • Sept. 1954 – Aug. 1955 (12 months)
  • May 1949 – June 1950 (14 months)

As long as you think prices will be lower tomorrow than they are today, you’ll keep postponing your purchases to get a cheaper deal. The more consumers put off spending, the more it hampers the economy, which, in the U.S. drives 70% of gross domestic product.

Also, as consumers pay less for goods, businesses become less profitable. In order to maintain profit margins, if businesses can’t raise prices, they have to cut costs. Jobs are lost. That just adds to consumers’ inclination to curtail spending as they worry about losing their jobs.

You can see where this is going. Businesses are now afraid of investing because the return on capital is harder to predict, and even the return of capital starts to become a concern. Debts become more burdensome as debt payments become a greater proportion of declining revenue.

Historically, deflation persists during periods of high unemployment, industrial overcapacity, stagnant wages and falling labor costs. A decrease in the demand for goods can result in oversupply. Ultimately, the velocity of money slows as money exchanges hands less frequently and prices drop. The money supply contracts, adding downward pressure. Deflation typically occurs during a recessionary period brought about by weak demand.

It is important to note that deflation is rare, most notably occurring in the U.S. during the Great Depression, in the U.K. during World War I, and more recently in Japan.

Japan infamously battled deflation for the better part of 20 years beginning in the early 1990s after bubbles in the Japanese stock and real estate markets collapsed. The world’s third-largest economy finally emerged from deflation in 2013.

Currently, the eurozone has faced price declines as it has struggled to recover from the Great Recession, particularly with the price of oil having fallen.

Indeed, oil accounts for much of the decline in the U.S. cost of living, as Federal Reserve Chair Janet Yellen noted in her testimony to Congress. Excluding the volatile costs of energy and food, consumer prices rose 1.7% in the latest 12 months. That is still below the inflation rate the Fed has targeted as a sustainable pace for economic growth.

Learn more
Focused on Inflation, by Adam Baley
Stronger Dollar, Weaker Inflation, by Bob Landaas

It’s important to be clear about the difference between deflation and disinflation, as well. Some articles concerned about deflation are really talking about disinflation, which is the slowing of inflation: Prices are still rising but at a lower rate. That is the case with the core CPI level, excluding food and energy costs.

Also, even the fall in oil prices isn’t just about weak demand. Lower prices have resulted at least in part from the supply of oil increasing with the growth in U.S. production from hydraulic fracturing.

Furthermore, the crippling deflation experienced during the Great Depression or in the U.K. during the Great War resulted from long, sustained deflation. Brief, isolated drops in prices occur occasionally, but markets tend to adjust so that supplies align with demand to keep inflation going. Before the Great Recession, the last time year-to-year declines in the Consumer Price Index lasted more than one month was 1955.

The best way an investor can manage risks of deflation all goes back to diversification and patience. Allocate investments to asset categories that tend to balance one another. Also, do not overreact to the news. Stick with your plan. Bond and cash positions are areas that hold up the best during severe deflation when there’s a rush to safety. So, even if the very rare occurrence ever comes to fruition, balance and level-headedness should prevail.

Tom Pappenfus is a registered representative and investment advisor at Landaas & Company.

(initially posted March 24, 2015)

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