Inflation, Deflation, and the Energy Boom

Written by Sandy Stuart

The European Union is experiencing deflation. Japan has just emerged from such an experience. The U.S. is trying to avoid it.  Other countries (like Russia) are experiencing rampant inflation. Perhaps it is time for us to review inflation and deflation so we can understand what we want our elected officials to achieve. This is especially true if we are retired, which I am.

First let’s look at inflation. Inflation is a loss of purchasing power. It is usually the result of an overheated economy. When I retired from the Army in 1981, we had inflation at about the 10% level. Inflation is the major enemy of and threat to retirees. Why is that? Retirees are usually on fixed incomes. We receive the same amount every month. Depending on the health of the economy, sometimes Congress will increase social security payments to help offset some of the inflation, depending on the health of the tax base. Sometimes.

Who are others who are hurt by inflation? Lenders are hurt. They may have made loans when the dollar was strong. But inflation weakens the dollar. So they are being repaid in currency that is worth less than the dollars they loaned. Investors in bonds and other debt instruments stand alongside lenders to share their pain. Of course debtors are just pleased as punch with inflation.

Investors who own assets are OK with inflation. If I buy a piece of real estate before a spurt of inflation, its “real value” (net of inflation) should be maintained. The value of the currency does not significantly impact the true value of the asset. Now, if the city decides to build a garbage dump next to my real estate, that will change its real value big time! But that is not a function of inflation…just my poor research before buying such an investment.

People in the retail sales industry are usually OK with inflation. They can effectively apply sales pressure with the line, “Buy now before prices rise!”  It is because of this attitude that inflationary economies overheat with a wage-price spiral. Sales are hot, workers demand higher pay checks and receive them because they are working overtime to meet the increased demand.

Deflation is almost the flipside of inflation.

When deflation bites, borrowers are hurt. They borrowed dollars that were worth less than they presently are. They must repay with dollars that have increased in value and purchasing power. Of course, the lenders are sitting in the cat bird’s seat. Like the lenders, bond investors are usually a pretty happy lot. If interest rates fall, which they should, lending-type investments normally increase in value.

Those who invest in assets, which include real estate (and stock), can become very nervous. As the dollar drops in value, the prices of assets valued in dollars also fall. In a deflationary environment with prices falling, consumers now have the advantage over the sales people and are asking themselves, “Why should I buy now, when I know the item I want may drop in price next month?” With this prevailing marketplace attitude, the economy can go into a stall or even a tailspin. Then workers start to be laid off. Wages drop. Gloom and misery!

Except for the retiree on that fixed income. He can buy more with his retirement check. If he has managed his finances reasonably well he will have paid off his home mortgage and is no longer a debtor. If he has a well-diversified investment portfolio, at least part of his investment portfolio will contain bonds and/or bond funds. Though the stock/asset portion of his portfolio may be falling, the bond portion will likely be perking up.

It is vital that investors be diversified. No one can say for certain whether we will be entering an inflationary or deflationary environment.  Then as the economy moves this way and that, we will have winners (with rising values) and losers (with falling values). Then we can sell some of the winners and buy some of the losers, buying low and selling high. That’s the name of the game.

It is also very important not to over-react to economic and portfolio changes. At the start of this article I mentioned that the developed nations, like the U.S., the European Union and Japan were either experiencing deflation or fighting it off. While this is technically true, currently falling prices in the U.S. are mostly due to the big drop in energy prices. This can be a good thing. Energy companies may have long faces, but dropping energy prices have lowered many costs of goods sold. That has increased profits and dropped prices in all business sectors for which energy is purchased, which is the vast majority of them. It is difficult to identify which industries do not benefit from lower energy prices.

And  I know that I, as a retiree in this deflationary environment, can visit my grandchildren and great grandchildren a lot more often and bring them better presents than I could a year ago. If this is what deflation feels like, bring it on!  In moderation of course.  After all, I want my children and grandchildren to keep their jobs.  I want to visit them, not have them live with me! That can be too much of a good thing.

– See more at: https://www.hscwealthadvisors.com/inflation-deflation#sthash.jbC0c866.dpuf