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MAKING CENTS OUT OF THE NEWS
Blog #23
(December 18th, 2008)
THE OTHER SIDE OF THE INFLATION COIN
By Tom McAllister, CFP™
With each new infusion of dollars into the U.S. economy by our government, I believe, the likelihood of inflation increases. In fact, I predict 5-7% inflation for 2009. Other observers however, are looking beyond the current inflationary pressures, asking themselves the "what if" question. If this enormous outpouring of government aid does not take hold and heal the economy, could we be in for a round of deflation instead? Capital is inflationary only if the credit markets are working properly -- and right now they aren't. It doesn't matter how much money the banks have right now, or how cheaply it can be borrowed -- if the banks won't turn around and pump that money back into the economy through consumer and business loans, deflation remains a risk.
Deflation is rare in our economy. We have had only two severe bouts of it in our history, in the years after the Civil War, and in the Great Depression. But now, concerns have been raised that, if the economic downturn continues, we might start shifting from rising prices to the opposite extreme - a destabilizing bout of deflation. While some deflationary pressure might sound like a good thing, it can be tougher on the economy than its more familiar opposite, and a lot harder to get rid of.
To fight inflation, a central bank can hike the target for its benchmark interest rate as much as it pleases. Higher rates ease inflation by making it more expensive to borrow money, which cools the cycle of borrowing, lending and spending. That pushes down demand – and, in turn, prices for goods, services and raw materials. The opposite medicine is used in a deflationary period – central banks lower rates, which makes borrowing cheaper and encourages people to spend, leading to higher demand that pushes up prices of goods and services. But with rates already slashed from 5.25 percent in early September 2007 to the current 1 percent, the central bank has very little room for rate cutting.
Based on forty six years of studying the economy and the markets, I believe there is less than a ten percent chance of deflation during the next couple of years. But what can investors do if deflation indeed sets in? Bonds with safe yields are a good bet in a deflationary environment, since fixed-income returns increase their buying power as prices fall. Stocks are trickier. Investors should favor companies with healthy balance sheets, as high debt becomes an added burden. Financial stocks could suffer for that reason, while retailers could go through tough times as they profit less from the goods they sell. "Necessity sectors" such as consumer staples, health care, and utilities are good places to look, as they are considered safe during unsteady economic times.
With all the rapid changes in our economy and in the investment markets, there are many investors who would benefit from more consistent guidance. We are currently accepting new financial planning and investment clients, and would appreciate your referrals.
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