As Inflation Fears Fade, Deflation Moves Front and Center

As the Federal Reserve winds down its massive bond-buying program, the widely predicted after effects — rising interest rates and inflation — have thus far failed to materialize. The yield on the bond market’s bellwether 10-year Treasury note, which started 2014 at 3.03%, had fallen to 2.33% as of October 29.1 Similarly, inflation, as measured by the U.S. Bureau of Labor Statistics key benchmark, the Consumer Price Index, has risen just 1.7% in the past year and has averaged 1.6% since the Fed first initiated its bond-buying program four years ago.2
Inflation ahead sign

Currently, concerns over inflation have been replaced by an opposite economic condition: deflation, defined as two quarters of falling prices within a 12-month period.3

Deflation, a Good News/Bad News Story

The paradox of deflation is that it can create good as well as bad conditions. When prices on essential goods and services drop, consumers are left with more disposable income to spend on nonessential items. Case in point: Plunging oil prices have spelled relief at the pumps, as the average national price for gas has now dropped below $3.00 a gallon for the first time since 2010.4

But when prices tend to fall across the board, the effect can turn negative for the economy, companies, and governments alike. Consumers put off making major purchases in the hope that prices will fall even further. That purchasing stalemate can be disastrous for a consumer-driven economy like the United States', which garners about 70% of its GDP from consumer spending.

When spending stalls, companies' revenues suffer and pressure mounts to cut costs by laying off workers, freezing or reducing wages, or raising the price of the goods they produce -- all of which can further stymie consumer spending and deepen the deflationary cycle.

Debt is the other major problem associated with deflation. On the consumer side, when wages are stagnant or declining, consumer spending power declines, and it becomes more difficult to pay off debts -- even fixed-rate debt such as home mortgages -- because the value of that debt relative to income increases.

The same scenario plays out for corporations and governments, causing cash-flow shortages, tax revenue shortfalls, liquidity problems, and even bankruptcy.5 Deflation fears are particularly pronounced in Europe, where sluggish economic growth has much of the continent teetering on the brink of recession. To a lesser extent Japan and China are facing similar woes.

On the Right Side of the Problem

The good news/bad news nature of deflation has everything to do with what is driving the drop in prices of goods and services. For instance, if it is a lack of demand -- as many economists say is currently the case in the Eurozone -- deflation could be damaging. If, however, it is due to a boost in supply -- such as the oil and gas boom in the United States -- it can prove beneficial to economic growth.6

Either way, analysts say that U.S. investors should benefit from current conditions for the time being. The S&P 500 Index has gained 6.3% thus far this year (as of October 26), while the Stoxx Europe 600 Index has fallen 0.3%. Meanwhile, virtually all major currencies are devaluing against the dollar in an attempt to export deflation to the United States.6

1 USA Today, "First Take: Beginning of the end of easy money," October 29, 2014.

2 U.S. Bureau of Labor Statistics, Consumer Price Index, September 2014.

3 The Economist, "The dangers of deflation: The pendulum swings to the pit," October 25, 2014.

4 AAA's Fuel Gauge Report, November 3, 2014.

5 Yahoo Finance, "Why deflation is so scary," November 3, 2014.

6 Bloomberg, "U.S. Gains From Good Deflation as Europe Faces the Bad Kind," October 26, 2014.

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Post by Phil Ratcliff

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