Today at TILE… The Deflation Scare

August 3rd, 2010

Today at TILE, we talked about the prospect of deflation in the economy. Is it really happening? Why does it seem economists and the markets keep changing their minds on the subject? What can even be done about it?

Imagine you are camping in a forest and you’ve made a fire to cook with – if it gets out of control, everything burns up and eventually you’ll have a problem on your hands. That’s kind of like rapid inflation. But if it burns out, you’ll end up cold, hungry, and probably pretty miserable. That’s more like deflation, and if there’s too much, it can be really hard to get that fire going again. In the world of economics, the goal is to have slow and steady growth – not too much and not too little. In other words, inflation is when the economy “heats up” – prices rise faster than the value of the currency being used to purchase goods and services. In contrast, deflation is when the economy “cools off” to the point where the world becomes too sluggish – prices of goods and services even start to contract, such that a vicious spiral of non-growth or negative growth can overtake us all.

How do we know deflation is upon us? Each day, week, and month the market watches indicators – pieces of data that help paint a picture of the economy and give us clues or signals as to where it might be going. All those funny acronyms (for example, CPI and PPI), government figures (e.g. Unemployment), and indices (e.g. the Case-Schiller Real Estate Index) tell us what happened in the past. Then the economists, market strategists, and investors use that information to make their own predictions about the future. Right now, as many articles suggest, investors are split and unsure about whether or not we face the threat of deflation. However, what is clear is that people are talking about it more and thinking about ways to “hedge their bets,” or make investments that protect them in the case we do find ourselves in a place where growth is limited and it is hard to find good investments (think stocks that go up or fixed income instruments that offer a decent yield or return on their money).

As the Japanese economy proved, once you start a spiral of deflation, it’s hard to change course. For example, if you know the car you want to buy will cost less in the future, you will probably wait to buy it. If everyone is constantly waiting to make purchases, then it feels like the whole economy is on hold – growth slows, investment slows, unemployment rises, etc… Most people look to the government, via government sponsored spending, and the Federal Reserve, via changes in interest rates (lower rates to encourage spending), to help ensure we don’t head in the direction of deflation. The goal is to keep us moving forward in a positive direction without crashing and burning in either direction – kind of like bumpers for bumper cars. Unfortunately, with interest rates already near zero and government budget deficits growing larger by the second, investors and economists aren’t sure government has either the ability or fortitude to make a difference. What if that pot hole in the road just never got fixed?

So what does this mean for the TILE community? First of all, the idea of the economy stagnating is pretty scary stuff. You aren’t alone. Sometimes it almost feels like it is taboo to talk about – as if just talking about it might make it happen (that’s behavioral economics at work). Second, the prospect of deflation might help you understand the connection between Washington, D.C. and the economy. Does the idea of the government spending more appeal to you? Do you like the idea of there being a larger debt for you, the future taxpayer, to have to address in the future? What happens if they don’t stimulate the economy now… is that better or worse? Finally, you may want to think about protecting your own portfolio… how will the stocks in your portfolio do in a slow or no growth environment? For example, do you own a lot of consumer stocks that depend on people buying lots of things? Or do you own companies that produce staples, like food or utilities, that will probably be in demand regardless of what happens? If you want income from the portfolio, are you more likely to “chase yields” today versus wait for higher yields in the future?

At the end of the day, none of us wants to be like the ostrich with our head in the sand. Take a look around, ask some more questions, and decide if you want to stoke the fire (buy yourself an iPad?) or be cautious about the future.

- Amy

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