Which Way Is It? Deflationary or Inflationary?

“The Financial World According to Inya” Column,
by Inya Ivkovic, MA

These days, economic reports sway us every which way — some towards deflation, some towards inflation. It is as if almost not a day goes by without predictions towards a decrease in general prices for a period of time, thus warning of deflation, just as there goes none without predicting that the level of general prices will rise. Much in our investing future will depend on adjusting our portfolios according to the future price direction. But which way will it be? Up or down?

Economics 101 teaches that deflation appears when prices of goods and services are trending downward for a continued period of time. One of the consequences is also a decrease in the money supply and/or credit. At face value, declining prices sound good to consumers. If we just wait for the downward spiral to work its spell, we are able to buy more stuff for the same amount of money. But such consumer psychology also means that the economic activity will slowly, but surely stop. Companies would run out of money from sales to fund operations. People would lose jobs and mortgages, car loans and debt from credit cards would slowly, but just as surely, eat bigger and bigger chunks of our incomes.

One way to fight deflation is to increase the money supply and ease the credit gates with reduced interest rates, so that new business could start and existing companies could grow. This is precisely what central banks in nearly every corner of the world have been doing to fight off the Great Recession. However, easing the monetary policy is a tricky business. If too much money is pumped into the economy while the output remains too low, then too much money ends up chasing after too few things, causing prices to rise, leading to inflation.

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Now, inflation is an entirely different beast from deflation. While personal debt as a percentage of personal income decreases, consumers’ purchasing power spirals down the toilet. If incomes do not keep up the pace with the rising prices and hyperinflation takes root, consumers may end up without enough money to buy even the necessities.

This is precisely the scenario that worries me the most. To boost the economic activity, central banks worldwide have infused trillions of dollars into global financial systems. As a result, governments around the world are barely breathing under mountains of debt and are now looking into the so-called “exit” strategies, whereby spending has to be brought under control and deficits have to be unraveled. The choices before us are difficult: should the government hike taxes, cut services, or print more money to shrink the debt?

For what it’s worth, here are my two cents. Knowing how politicians think and worry about one thing only — re-election — the obvious choice is printing more money. That will mean eventual inflation, not in the short term, but not too far long down the road either, hoping that at least economic activity will pick up the pace.

Having in mind inflation rearing its ugly head in the medium to long term, here is what I believe investors should do. For starters, they should stay away from the currencies that governments are the busiest printing out, because those currencies will be the first and the fastest to lose value. Second, they should focus on tangible, hard assets, such as gold and other precious metals, gold-related stocks, and even real estate stocks, and shares in companies that have a sporting chance of beating inflation. Just do not forget that there is no such thing as a “safe investment.”

If these investments are too risky for you, and I agree they may be speculative in nature, there are “safer” options, too, such as real-return bonds, for example, which have embedded features to adjust to the inflation rate. You could even go for real-return bond ETFs (exchange-traded funds), some of which have very low MERs (management expense ratios) and could be an affordable way to keep one’s returns in line with inflation and stay in the safe zone at the
same time.

Just remember, no one really knows what the future holds or which one, deflation or inflation, will be making an appearance in the coming months and years. My instinct is towards inflation, but the best way remains a diversified portfolio and a watchful eye on the Consumer Price Index (CPI). The rule of the thumb is, if the CPI jumps over the two-percent mark, chances are that inflation is accelerating. And if the tide turns differently and deflation grows its roots deeper, I would say cash remains king for a while longer.