WHAT IS INFLATION? DEFLATION?
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Listen to any recent newscast, or read any newspaper and you will probably hear the terms Inflation or Deflation.
But, unless you had a college economics class, or maybe even if you did, you may find yourself asking “what is inflation”?
There is currently a debate taking place among economist as to which of the two we might face in the near term. Here is the argument.
INFLATION
Inflation is commonly defined as a rise in the general level of prices of goods and services in an economy over a period of time. In other words, the goods that you buy are getting more expensive.
While there may be considerable debate over the causes of inflation, much of the current debate centers around the economic impact of all the cash that the Federal Reserve is pumping into the economy. The worry is that there has been so much money injected into our economy, in an effort to stabilize the financial sector and stimulate the broader economy, that all this extra money, along with a low interest rate environment, will lead to inflation in the form of higher prices.
How? Well the fear is that all the available money in the system, combined with low interest rates, will make it easy for businesses and individuals to borrow money. Once borrowed, the money, in theory, will be spent on goods or services. With so much “easy money” in the economy, the demand for goods might outpace the availability of goods (supply and demand) and therefore, prices could increase.
Think about the recent residential real estate boom and how easy-money helped fuel the bubble and inflated housing prices.
Another concern is that the increase of available money in the system is being generated by our government printing money, effectively creating a situation where each dollar is worth less and therefore leads to price increases.
The manufacturer will require more dollars for her produced goods if she knows that each dollar received is worth less. She will do this by increasing prices.
Of particular concern is hyperinflation. A situation where a debased currency causes rapid and severe price increases in prices over a short time.
The current concern is whether the Federal Reserve can withdraw these large sums of injected stimulus monies fast enough to prevent serious inflation once the economy begins to strengthen and grow. The challenge is to identify WHEN to begin withdrawing, and to withdraw in a sufficient, timely and safe manner.
Safely means not causing damage to the debt markets and not pulling so much out so quickly that we actually go too far and head back into another recession.
DEFLATION
The opposite side of the debate centers around the possibility of our economy experiencing deflation in the near term. Deflation is the opposite of inflation and is defined as a decrease in the prices of goods and services over time.
Effectively, deflation leads to an increase in the real value of your money. When prices decrease, your dollars can purchase more and are therefore worth more.
This may sound good at first, but a deflationary scenario presents some other concerns. When a business has to accept lower prices for it’s goods and services, profits will eventually decline.
Declining profits may lead to financial stress for the company and further lead to expense cutting in the form of layoffs for employees. Employees that don’t have incomes tend to spend much less than before, and others may increase their personal savings out of fear of potentially losing their job.
Both of these scenarios lead to reduced consumption which may lead to further price cuts by business. You see the trend here. Additionally, those employees that have been laid off, may find that any new job they land, may come with a smaller salary. And, in periods of deflation (negative inflation), those workers that don’t lose their jobs will most likely receive much smaller raises, if any.
So you can see how deflation can lead to a vicious downward spiral if allowed. Prices go down. Companies struggle. Wages go down and unemployment increases. Companies have to reduce prices further to move their products to consumers that aren’t in the mood to purchase. You get it.
One other topic of concern associated with a deflationary experience is that of a liquidity trap. You see, one method of preventing or correcting deflation is to stimulate the economy by the Federal Reserve injecting money into the banking system (as described above-see INFLATION). However, a liquidity trap occurs when the government continues to pump money into the system, but experiences a diminishing or non-existent return for their efforts. In other words, money keeps coming in, but the desired growth stimulation to the economy doesn’t follow. Some economist believe our economy may be experiencing this now. There can be several reasons for this and I would like to address a few that I think are particularly relevant to our current situation.
THE TAKEAWAY
Economists and professional investors are mixed on whether inflation or deflation will occur first, or if we will possibly experience both. The fact is that we need to ensure that our government proceeds cautiously and in the best interest of the economy rather than any competing political objectives. It is commonly accepted that printing too much money by a Central Bank (The Fed) will ultimately lead to high levels of inflation. Your efforts to increase your Financial Literacy will assist in recognizing if your elected officials are serving you properly.
As an investor you should educate yourself on the impact of inflation and deflation on an investment portfolio. Learn the impact of inflation and deflation on various asset classes such as cash, commodities, stocks and bonds. Then study our current economic climate and follow the actions of our government leaders to arrive at your own conclusions regarding our near and medium term economy. You should then analyze any current investments in the context of your conclusions and act accordingly.
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