Worried By Deflation?

Jan 20, 2015 by

The financial, and even the non-financial, media are using the “D” word—deflation—more and more often. One reason is that the US 10-year Treasury bond yield is 1.81% as of this writing. To put that in context, here’s a graph of the 10-year Treasury yield back to 1962.

S&P 500 chart

And the 30-year Treasury bond’s yield currently is 2.45%—the lowest ever. (Further, the Consumer Price Index fell 0.4% in December. And for 2014 the CPI rose a scant 0.8%.)

The reasons underlying incredibly low bond yields are complex and multi-faceted, but one is clear: the U.S. government bond market is forecasting very low, and perhaps negative, inflation. “Negative inflation?” Yep, otherwise known as deflation.

What is Deflation?

You know what inflation is: a rise in the general level of prices for goods and service. Deflation is inflation’s alter ego: a decline in the general level of prices for goods and services.

Knowing that, your reaction to the prospect of deflation may be: “Bring it on!”

Not so fast, bub. Let’s think this through.

How Deflation Affects the Economy

Americans alive today have never experienced deflation in their home country. Inflation has become so ingrained in our psyches that we likely don’t realize the degree to which our consumption behavior, investing strategy, and personal finance management implicitly assume at least a modest level of inflation.

What if you knew you could buy that new refrigerator for, say, 3% less if you waited a year? Then what if you had the same choice a year from now: wait another year, and get the fridge for even less. You might put off buying that fridge until you wake up one day and your food’s rotten. Not counting the food loss, this might seem at first blush like a fantasy world for consumers where the longer you hold out, the bigger bargain you get.

deflationBut what about refrigerator manufacturers? And their employees? And their shareholders? And all the retailers that sell fridges? While you and everyone like you are saving money on the cost of refrigerators by postponing purchases, these companies would be hurting, big time. And they wouldn’t be raising wages as they might when inflation prevails. Many collective bargaining agreements include cost-of-living wage increases. But what if the cost-of-living is declining? Bye bye wage increase rationale, (unless of course you’re a corporate executive).

Spread this phenomenon across the whole economy, and we’ve got a bit of a disaster on our hands. The U.S. economy is 70% consumer-driven. If we long-time spendthrifts suddenly become savers, big chunks of the economy are going to tank. Right or wrong, the U.S. economy is addicted to people spending most every nickel they can earn or borrow. Going cold turkey will send the economy into an ugly, and possibly prolonged, withdrawal period.

Deflation and Debt

When INflation prevails, a fixed debt payment, measured in real (uninflated) dollars declines over time. For example, if inflation averaged just 2% over the life of your 30-year mortgage, your final $800 principal payment on the mortgage would be equivalent to $442 measured in dollars of the same value when you took out your mortgage, thirty years earlier. Another way to think of this is that, at the end of your mortgage term, the same basket of goods & services that cost $800 at your mortgage period’s end would have cost only $442 thirty years ago.

Measured in terms of goods & services, your mortgage principal payment is getting cheaper and cheaper when there’s inflation. Thirty years ago your mortgage payment was “worth” 250 gallons of milk; at the end of your mortgage, the same $800 payment is worth only 150 gallons of milk. Your payment is fixed, but milk got more valuable—measured in nominal dollars—at the rate of 2% per year for 30 years. If your mortgage lender accepted milk as payment, your payment would have dropped by 100 gallons—or 40%—over thirty years.

What would happen if 2% DEflation prevailed over the life of your 30-year mortgage? Your final $800 principal payment would be equivalent to $1,449 measured in dollars with the same value when you took out your mortgage.

This means deflation kills debtors. When deflation prevails, debt payments become more and more expensive, measured in terms of goods & services. With 2% deflation and our mortgage lender who accepts milk as payment, your principal payment at the end of your mortgage would be 480 gallons of milk, nearly twice as many gallons as your first payment, thirty years prior. Said differently, your constant $800 payment is worth a lot more milk—our proxy for goods & services—than it was thirty years ago!

When deflation prevails, debtors feel poorer and poorer because fixed debt payments are worth more and more goods & services as the price of these goods & services deflates. You’d be giving up more and more goods & services in lieu of a fixed monthly payment over years of deflation.

Deflation and Investing

I think cash has always been king, but especially in deflationary times, cash is really king. With deflation, less and less cash is required over time to buy the exact same good or service. In terms of the goods & services it can buy, cash gets more valuable as time passes, when there’s deflation.

“Cash is King” during deflation applies to corporations and individuals. Companies with lots of cash and relatively little debt are likely to perform better (not necessarily well—just better) during deflation than cash-poor, highly leveraged companies. The same goes for people.

Cash is king means investments that generate cash are likely to be preferred. Bonds and the good ol’ FDIC-insured Certificate of Deposit we’ve all forgotten will gain popularity in deflationary times. A CD with a 2% interest rate actually yields 5% when deflation is 3%.

What do you suppose would be the effect on stock values if boring, risk-free CDs become an attractive investment? It wouldn’t be pretty.

Should You Prepare for Deflation?

No one—least of all me—is smart enough to predict reliably whether deflation will hit the U.S. But you know what? Paying down debt is never a bad idea, and just might be an especially good idea right now. Similarly, building an emergency fund is also always a good idea, but might prove especially wise if you work for a business likely to suffer during deflation.

And what about stock investing? Stocks are always risky, and deflation would add to the already considerable list of reasons why. The S&P 500 Index has moved from 800 to 2000 over the past six years, a 150% increase. Wise if not particularly insightful people once said:

  • No one ever lost money selling for a profit.
  • Buy low, sell high.

Do you expect deflation?

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