Inflation Versus Deflation

The subject of deflation has been amply discussed this year. Deflation is the result of prolonged weak consumer demand that may cause a recession and even a depression. The most severe period of deflation, over the past century, occurred in the very late 1920’s and for the entire decade of the 1930’s during the Great Depression. With the low inflationary environment that has persisted for several years, and supply outpacing demand, new discussions of deflation are not surprising. However, as the U.S. budget deficit increases and while the U.S. economy shows signs of a recovery, inflationary concerns have risen. Inflation is a sustained rise in overall price levels. As the economy grows, businesses and consumers spend more on goods and services. In the growth stage of an economic cycle, demand typically outpaces the supply of goods. This allows producers of goods to raise their prices causing the rate of inflation to increase.

One force that contributes to inflation is rising commodity prices. When commodities rise in price, the cost of basic goods and services typically increases. Specifically, higher oil prices can have the most significant impact on the economy. Higher oil prices lead to a rise in gasoline prices and diesel fuel. Therefore, any goods or services that are transported by truck, rail, or ship will rise in price. In addition, as jet fuel prices rise, airline ticket and air transportation costs increase. Also, higher heating oil prices will hurt consumers and businesses as well. Surges in oil prices were followed by recessions or stagflation – a period of inflation combined with low growth and high unemployment in the 1970’s, 1980’s and early 1990’s. Another factor that may spur inflation is exchange rate movements. As a country’s currency depreciates, it becomes more expensive to purchase imported goods, which puts upward pressure on prices overall.

Inflation also has a negative impact on real savings and investment returns. Investment returns must first keep up with the rate of inflation to increase real purchasing power. For example, an investment that returns 2% before inflation, when inflation is in an environment of 3%, results in a negative 1% return after adjusting for inflation. Inflation impedes fixed income (bond) returns. Fixed income securities offer a stable income stream in the form of interest, or coupon payments. However, because the rate of interest, or coupon, on most fixed-income securities remains the same until maturity, the purchasing power of the interest payments declines as inflation rises. Furthermore, when inflation rises, interest rates tend to rise either due to market expectations of higher inflation or because the Federal Reserve has raised interest rates to help fight inflation. When interest rates rise, bond prices fall. Therefore, inflation may cause bond prices to decrease, which dampens the total return on bonds. Unlike bonds, some assets rise in price as inflation rises.

Common stocks, measured over a long period of time, have been a good investment during inflationary environments. This is true because companies can raise prices for their products when their costs increase due to inflation. When companies have the power to raise the price of their goods or services, greater earnings may follow. On the other hand, over shorter periods of time, stocks weaken when inflation unexpectedly surges. When inflation rises suddenly, it contributes to some uncertainty about the economy, which leads to downward estimates for corporate earnings. Ultimately, stock prices realize the same fate.

Another good investment, and perhaps the best when inflation rises is commodities. They are some of the primary components that drive inflation.

To protect against the negative impact of inflation on a bond portfolio, floating rate securities (examples include bank loans and adjustable rate mortgage securities) offer some favorable prospects. Floating-rate securities offer coupons that rise and fall with key interest rates. The interest rate on a floating-rate security is reset periodically to reflect changes in a base interest rate index, such as Treasury Bills, prime rate, or the London Interbank Offer Rate (LIBOR), a type of international prime rate. Therefore, floating rate fixed income securities may react favorably in an inflationary environment. Also, Treasury Inflation-Protection Securities (TIPS) are inflation-linked bonds that offer some protection for investors from inflation because both their principal and their interest payments adjust as inflation changes.

The U.S. Federal Reserve (the Fed) attempts to control inflation by regulating the pace of economic activity by raising and lowering short-term interest rates. This process is often referred to as monetary policy. Lowering short-term rates encourages banks to borrow from the Fed and from each other. This helps to increase the money supply within the economy. Banks, then, make more loans to businesses and consumers, which stimulates spending and overall economic activity. Raising short-term interest rates typically discourages borrowing. This decreases the money supply, which reduces economic activity, thereby taming inflation.

The federal government may attempt to temper inflation through fiscal policy, by raising taxes or reducing spending, which may slow down economic activity. This minimizes the threat of inflation. On the other hand, low inflation or deflation, can be offset with tax cuts and increased spending designed to stimulate economic activity. The federal government and Federal Reserve Board often walk a fine line trying to stimulate economic growth without inflation.