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DeflationGate

| February 23, 2015
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Let’s talk about deflation. While it may be good for throwing a football, it’s generally bad for the economy. As many of you may know, I was born and raised in Boston, MA.  So to start, let’s get all of the vitriolic DeflateGate jeers out of the way.  Think them, mutter them under your breath, shout them at your computer screen for all I care.  None of that negative energy will change the fact that the New England Patriots are the best team in the NFL and that Tom Brady should probably be our President!  Is this current events-focused, controversy-laced intro just a cheap ploy to gain traction with my audience on a brutal topic like deflation?  Yes. Yes it is.   

Let’s first define ‘deflation’ in terms of economics.  Deflation is a decrease in the general price level of goods and services in an economy.  In other words, it is a negative rate of inflation (i.e. the jacket that I purchased last year for $200 now costs $180 a year later).  Doesn’t sound too bad on its face.  Who wouldn’t prefer for the price of a planned purchase to go down?  More to come on that question in a bit.  I read about deflation literally every day as I peruse through my various reading materials (Wall Street Journal, Barron’s, Bloomberg, etc.).  In the world of economics, deflation is generally thought of as a dirty word.  There is such a stigma attached to the concept of deflation that central banks around the world are currently putting forth massive efforts to stave it off and to spur inflation within their economies.  Deflation occurred in the U.S. during the Great Depression era and for a short period during the recent financial crisis of 2008-2009.  We’ve also seen the Japanese economy deal with several bouts of deflation since the 1990’s.

While all of this ultimately ends up in the same pot (the overall economy), let’s look at deflation from the perspective of both consumers and businesses.

Consumer:  Let’s say you really want to buy something that’s going to make a huge difference in your life.  Something that everyone can agree is incredibly valuable, a game-changer……..like, um, a deflated football (trying my best to tie all of this together).  Let’s say a premium, genuine leather, pre-deflated football ran $100 a year ago and currently sells for $90.  Wow, what steal! That’s a 10% discount compared to last year’s price.  Sign me up!  Not so fast.  What if the price had been $111 just a year before that?  Furthermore, what today’s $90 price is generally expected to drop to $81 a year from now?  Are you still anxious to buy right now?  That’s what happens in a deflationary environment.  People are hesitant to purchase goods now because they expect the price to drop in the future and don’t want to over-spend.  So what do consumers do during periods of deflation?  They hoard cash and don’t spend for fear of missing out on future lower prices.  That’s not such a big deal, is it?  Well, to answer that, let’s cut to the business perspective of deflation first……..

Business:  If a business noticed that sales, revenues, and ultimately profits were dropping over time (from consumers cutting back spending), what will they likely do?  Cut costs.  How might they do that?  They go straight to cutting capital spending and laying people off (see any current article about the state of the energy sector in response to a 60% drop in the price of crude oil).  If people are laid off, they obviously have less money in their pockets and want to derive as much value as possible with the dollars that they do have to spend.  So, if you want to stretch your money, do you buy now, or later when the price of goods has dropped?  The answer is later, of course.  That’s not good for companies that sell goods.  If demand for a company’s goods has dropped, are they willing to invest millions in new property, plant, and equipment?  Probably not.  This means lost employment opportunities for those who are in the business of selling/building property, plant, and equipment.  This is a vicious cycle.  In addition to layoffs and capital spending cuts, another issue for both businesses and individuals is that deflation grows the value of the debts owed in real terms.  Deflation makes currency more valuable and as such, those fixed payments that you owe to a lender are worth more.  If the money that you’re handing to a lender is worth more, it effectively is increasing your interest rate that you agreed pay them at the outset of your loan.  Inflation on the other hand has the opposite effect (talk to your grandmother about her mortgage payment that was likely a few hundred dollars per month).  Having the value of your debts effectively grow is no fun for businesses or consumers.

To tie this together we need to talk about Gross Domestic Product (GDP).  GDP measures the value of all goods and services produced in an economy.  GDP growth or contraction is essentially the crown jewel of economic data points as it’s a barometer for the health of an economy.  How is GDP calculated?  Forgive me, and while you’re at it, grab a cup of coffee, but here’s the equation:

GDP = C + I + G + Net Exports

The terms in the equation above are Consumer Spending, Investment (business capital expenditures), Government Spending, and Net Exports.  Let’s not beat around the bush………consumer spending comprises approximately 70% of GDP and this item decreases dramatically in a deflationary environment because people delay purchases.  As I mentioned above, business investment drops as well, and deflation leads to a stronger currency, which makes your country’s goods more expensive, which lowers net exports.  In summary: not good.  I’m assuming that we can all speculate as to what type of effect this type of an environment might have on many of your investments……..once again, not good, with the exception of your fixed income/bond investments where you are a lender (see above discussion about deflation increasing the real value of debts) of money to a government or business entity. 

So, why write a deflation blog post?  First of all, it’s a fun topic (kidding) and because talk of deflation is all around you and it’s very important to all of us.  When you turn on the television and hear about the latest Fed minutes, the direction of interest rates, QE (quantitative easing), unemployment figures, CPI and PPI (inflation measures), currency wars, etc. it all ties back to a massive effort on the part of worldwide central banks to fight off this beast called deflation.  How will it all end?  No one knows, but this issue is something to be aware of. What’s the good news?  We seem to be doing a much better job of fighting deflation than our friends in Europe and Japan, and also, the Patriots just won their fourth Super Bowl!

By: Andrew Gonski

The opinions voiced in this material are for general information only. Examples are hypothetical and for illustrative purposes only.

 

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