Concerns Over Deflation

Here is another great article today by our friends at the Mortgage Market Guide about recent deflationary concerns.

“We have received a number of questions recently voicing concerns about the possible effects of a deflationary environment on the economy and possible effects of a weaker dollar on interest rates. Let’s take a look at the prospect of deflation first, and yes it is a potential problem as pointed out recently by Fed Chairman Alan Greenspan.
Most people living today have never experienced a true deflationary environment. The last one was the Great Depression. Many economic historians believe the Great Depression was triggered by Fed interest rate hikes occurring precisely at the worst possible time. The Fed (along with many of the world’s major finance ministers) is very aware of the current potential deflationary problem and has pledged to take whatever steps are necessary to try and prevent a scenario of full-blown deflation from taking root. Here is a summary of key points describing what takes place in a deflationary environment:

  • Deflation seemed to be a remote possibility several months ago, but has now turned into a real concern for the U.S. and global economy.
  • Deflation is the actual decline in prices. Disinflation is a decline in the rate at which prices are going up.
  • It sounds good for consumers, but it’s actually harmful for the economy.
  • A drop in prices hurts profit margins, and companies will try and reduce costs by cutting jobs or lowering wages.
  • Such corporate behavior would lead to a drop in consumer and business spending, causing prices to fall further.
  • Falling prices will hit all asset classes eventually, like real estate. If your real estate is worth less, you can’t borrow as much against it, reducing your credit.
  • Reducing credit leads to further deflation.
  • Although Japan has been fighting against deflation for a long time, the U.S. can’t apply what has been learned from Japan because the two are different.
  • Japan is a creditor nation, while the U.S. is a debtor nation.
  • For any debtor nation, you need some inflation to eventually inflate away your debt.
  • Bonds are the best investment in a true deflationary environment.
  • However, there is no guarantee a deflationary environment will occur at this time.
  • Companies that are less vulnerable in a deflationary environment include ones with strong cash flows, and little debt.
  • Investors should avoid companies that are involved in commodities, as they have no pricing power.”

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