Be Prepared for Inflation and Deflation

During the spring and summer months last year, one could hear a distant cry, “Bring on deflation.” Even Federal Reserve Chairman Alan Greenspan abruptly started to warn about the economic outlook regarding deflation. That made potential investors stop and think that such an event might actually take place, even though they were not exactly sure what it meant. However, in the past few weeks, the tables have turned, and inflation has been more of a topic of discussion. So, should investors be anticipating inflation or deflation?

The markets can tolerate moderate inflation or deflation quite effectively, but too much of either can be very detrimental. Unfortunately, predicting the economy is nearly impossible. Even Alan Greenspan doesn't guarantee that an investment will earn that extra dollar or the stock market will be strong. The economy is a complex matrix of ideas and events, driven by raw factual information and data, coupled with gossip, street talk, and perceptions.

With inflation or deflation at the forefront of many conference room discussions, the key to understanding either is acknowledging that they're purely monetary phenomena. Inflation and deflation are caused by the fluctuation of money available to spend weighed against the goods and services available to purchase.

Effect of Deflation

The concept:

SmartMoney

Deflation occurs when the supply of goods or services exceeds consumer demand, resulting, usually, in falling prices. A consumer's motivation to buy is severely moderated when prices are perceived to be steadily declining. Why is this? If consumers delay their purchases and prices continue to decline, they will be better off paying for the same product at a cheaper price sometime in the future. If prices, however, increase from the bottom, they still have enough money to purchase the products they need. During the Cold War, consumer demand, based on price uncertainty, tended to decrease. According to a article, “Retailers wouldn't even stock inventory, waiting until they had a sale before placing the order. And who was going to buy a new refrigerator they couldn't see?”

Let's look at this from a business standpoint. Let's say that you're a manufacturer and your primary expense of manufacturing your particular product is various steel components. After many years of rising prices for ball bearings and other machine parts needed in your manufacturing endeavor, these costs suddenly decline. Your cost of replacing raw materials is dramatically reduced. That leaves more capital for physical plant investments, marketing and employee expenses, and enticing investors with improved earnings results and possibly increased dividends.

Deflation, in this particular scenario, may look great, but what happens when you put on your other hat and become a supplier of your finished product? Producers always desire to sell their products at the highest price possible and purchasers want to get everything for something less. This give and take generates market price. When prices dramatically decline, sellers are in trouble. If competition and other economic factors come into play, whereby the seller cannot recover costs, their bottom- line profits dramatically fall. As we can see, a deflation tsunami would level out market strength, but where does inflation fit into this picture?

Effect of Inflation

Webster's Dictionary

As classic historical economists know, a money supply increasing faster than what is being spent will inevitably lead to inflation. According to , inflation occurs when there is a “substantial rise in the general level of prices related to an increase in the volume of money and results in the loss of the value of currency.”

When the dollar of today is worth double the dollar of tomorrow, we have inflation. The knowledge that the dollar will be less valuable tomorrow logically will evoke mass spending. Inflation, and the rational way consumers react to it, causes great misery for an economy. Consumers are less likely to engage in potentially profitable deals that involve future payments because they are unsure of the value of money vs the current value or means of exchange.

The belief in money and the steady value of the currency are not innocuous notions. According to the University of Rochester Economics Department, if citizens lose faith in the money supply and believe that money will be worth less in the future, future economic activity could grind to a halt.

With the current economic state, we will most likely see inflation, rather than deflation. I am not anticipating a large-scale inflationary state, but it would be wise to start preparing for some inflation.

John Valentine specializes in portfolio management and in developing high-net-worth strategies. He is the principal investment advisor at the Valentine Capital Asset Management of San Ramon, Calif. He welcomes questions or comments at 925-275-0200, or visit www.vcrpg.com.