Inflation or Deflation?

Ever since the massive Government response to the 2008 financial crisis, a number of market observers have predicted higher than normal inflation for the U.S. economy.  That, however, has not been the case.  More recently, we have other market observers looking at a generally weak global economic recovery and believing we have entered a period of lower than normal inflation or even deflation.  In this edition of Financially Speaking, I want to take a closer look at exactly what these terms mean and why predicting the coming economic path is a challenge.  As always, comments and opposing views are welcome.

A History of Inflation

The definition of Inflation is “a sustained increase in the general price level of goods and services in an economy over a period of time”.  The U.S. Federal Reserve (Fed) generally targets a level of +2 per year inflation.  The Fed logic is that 2 inflation is low enough to not disrupt the economy, while being high enough to avoid deflation (the general decreasing of prices over time).  The idea of positive, low inflation makes sense.  Positive inflation tends to keep interest rates positive, giving money held in banks some growth.  It also tends to keep wages on an upward path, which supports consumer spending and savings.  And it tends to move asset values, such as homes and stocks, in a positive direction.  Most would consider these to be good outcomes.  Too much of a good thing, however, can be problematic.  If we look back at the 1970’s, we find an example of how higher inflation levels can create an economic mess.  Annual inflation got as high as 14 by 1980 and a newly appointed Fed Chairman had to raise short-term interest rates to slow the economy and ultimately push it into recession.  It took until 1983 before inflation rates came down to more normal levels.  Those who remember that time may have appreciated owning Certificates of Deposit paying 8, but with unemployment over 10 and mortgage rates hitting 18 in 1981, it is generally not considered a good economic time.  Some believe the cause of what is now referred to as the “Great Inflation” was rising oil prices, but most economists now agree that the inflation was driven by the Government monetary policy of deficit spending (on the Vietnam War and social programs) combined with the declining value of the U.S. dollar.  This view is consistent with well-known economist Milton Friedman who postulated that inflation was always “a monetary phenomenon”.

Improving Conditions

While it may seem that deflation would be good, it really isn’t.  Again, from a social view, lower prices over time takes away most consumer’s incentive to spend.  Why buy something today if you can wait a month and the price will be lower?  That lack of consumption spending is bad for businesses and employment.  Japan has suffered with deflation, or very low levels of inflation, often referred to as dis-inflation, for over 20 years.  It does not make for a robust economy.  Europe is on the cusp of deflation at 0 annual inflation as of April.  It is generally accepted that deflation is bad and to be avoided.

Looking back at the 2008 financial crisis, the U.S. went on a deficit spending binge of historic proportions between 2009 and 2012.  Those who foresee high inflation connect this period of deficit spending with what happened in the 1970’s.  So, where do we stand today?  Well, the “core” Consumer Price Index (CPI), which removes volatile food and energy costs, is registering +1.8 from a year ago in April.  I find 1.8 to be quite close to the 2 target.  In contrast to the 1970’s, today’s U.S. dollar is not weakening, but gaining, strength.  Herein lays the debate.  Will the recent deficit spending result in high inflation, or will the low levels of global inflation push the U.S. toward deflation?  I believe a reasonable argument can be made for either view.  That said, with U.S. inflation of 1.6 in 2014 and the current rate at 1.8, the momentum seems to be on the side of higher inflation.  For investors, I wouldn’t chase inflation protection with overwhelming zest, but I think some degree of protection is warranted.  Who is to say that we won’t see 2 or more by the end of 2015?

Barron Financial Group, LLP is a fee-only Registered Investment Advisor regulated by the Connecticut Department of Banking.

This newsletter is for general information only and should not be considered investment advice.  Investors should consult with a trained investment professional to discuss their particular situation.