Deflation: Should you be worried?

October 22, 2010

The investment consensus has shifted recently from inflation worries to concerns about deflation.

Key Points

Inflation is an increase in the cost of products and services over time. We have grown accustomed to most things, excluding high-tech items such as computers, becoming more expensive each year. Deflation is just the opposite, a decline in prices each year. It's as if you put a dollar in a flower pot, watered it, and watched the bill grow larger. Finally, you would "pluck" it from the dirt and use it to purchase an ever-increasing number of items each year. Well, what's wrong with that? Let's see.

DEFLATION CAN BE AN INCENTIVE TO SAVE

You can argue that our country, which has experienced high spending and low savings until recently, could benefit from a boost in its savings rate. However, with the administration attempting to spur growth, now is not the time to soften consumer spending. Besides, in a weaker environment, businesses often postpone capital expenditures and reduce inventory, thereby making things worse. The combination of lower spending by these 2 economic sectors could, in the absence of higher government outlays, bring about sluggishness or even a downward spiraling of our economy. In fact, that's just what happened during the Great Depression.

INFLATION COULD RETURN

Although prices for goods could decline for a few quarters, I believe an extended deflationary cycle is not as likely as an upsurge in inflation. Inflation has appeared to moderate recently, but it still is significantly positive. Our government would do all it could to prevent deflation because it is more difficult to control than inflation, and higher unemployment would most likely result from it.

The Federal Reserve's words and actions, which have brought interest rates even lower, should encourage purchases of more speculative investments; this could trigger higher stock prices and increased capital expenditures for businesses, both of which could accelerate economic growth and eliminate deflationary forces.

For the first few years in a deflationary environment, investors are better off buying bonds. What looks like a puny interest rate looks better in inflation-adjusted terms. Moreover, bond prices rise when rates decline. Stocks with above-average yields in industries such as drugs and food can also work out well. Finally, repayment of debt, including prepayment of mortgages, can make sense.

However, before you place monies in low-yield bonds, recognize that if deflation fears turn out to be a passing fancy, as they were about 7 years ago, any significant resurgence of inflation would result in large losses for those securities bought as a deflationary hedge. For example, U.S. Treasury bonds lost almost 10% in 1 month during the summer of 2003. Bond yields, particularly on high-quality debt on which the interest rate has declined sharply recently, would be particularly vulnerable. Over the long term, I still believe inflation is the greater threat.

The author is president of Altfest Personal Wealth Management, a financial and investment advisory firm in New York City; an associate professor of finance at Pace University, and a Medical Economics editorial consultant. The ideas expressed in this column are his alone and do not represent the views of Medical Economics. If you have a comment or a topic you would like to see covered here, please send it to medec@advanstar.com