Inflation or Deflation? A Simple Guide.
Inflation and deflation are simple economic concepts that everyone should (and can!) understand but their widespread use by the media to generate buzz has left them misunderstood. Unfortunately the fear and uncertainty created by the media’s use of these words means most people simply think of them as “bad” or worse — just something for economists to kick around.
Inflation and deflation are not objectively good or bad, but they both play a critical role in a modern economy. Inflationary or deflationary economic climates drive important things like monetary policy, spending habits, and investing. So what exactly is deflation and inflation?
Inflation
Inflation simply means that the prices of goods and services are rising.
Simplistically this means that the purchasing power of a currency is going down. Under inflation a candy bar may cost $1.00 today and $1.10 tomorrow.
What does inflation do to an economy? Inflation stimulates spending. If prices are going to be higher in the future it makes sense to purchase goods and services today. If that new 50" tv you want is going to cost more next year why not just get it this year? Additionally, inflation spurs investment. If $100 left in the bank (assuming 0% interest) this year will only purchase $90 worth of goods and services next year then leaving your money in the bank is a money losing proposition. Who wants to lose money? Nobody does, so people invest. If you can invest your money in stocks and generate a return in excess of inflation you are not only making money, you are also avoiding losing money to inflation. This is part of the reason retirement investment accounts are so popular.
Is inflation normal? Yes! Whether it is good or bad is a topic of intense discussion but in the US it is normal. The Federal Reserve targets an average inflation rate of 2%. The idea behind this policy is to encourage people to buy goods and services and to invest based on the logic explained above.
Examples of inflationary assets are major currencies such as the United States Dollar and the Euro.
Deflation
Deflation simply means that the prices of good and services are falling.
Simplistically this means that the purchasing power of a currency is going up. Under deflation a candy bar may cost $1.00 today and $0.90 tomorrow.
What does deflation do to an economy? Deflation stimulates saving. If prices are going to be lower in the future it makes sense to wait and purchase goods and services tomorrow. If that new roof for your house is going to be cheaper next year it is more prudent to wait and purchase the roof in the future (assuming your old roof isn’t leaking!). Additionally, deflation discourages investment. If $100 left in the bank (again assuming 0% interest) this year will purchase $110 in goods and services next year then leaving your money in the bank is a money making proposition. You are essentially making money at zero risk. Who wants to take on excess risk? Nobody. People are generally risk averse so instead of investing in a risky stock market they choose the safer savings account. It’s easy to see that deflation is generally harmful to an economy. People are incentivized to save and spend money in the future vs. spending money today.
Is deflation normal? Not really. Again whether it is good or bad is a topic of discussion but generally in US history deflation is uncommon. The Federal Reserve tries its hardest to avoid deflation for the reasons listed above. Generally it’s hard to grow Gross Domestic Product (GDP) during a deflationary climate — a knock-on effect from the Fed’s mandate. By targeting a 2% inflation rate the Fed will use all the tools in its monetary policy toolbox to avoid a negative inflation rate (deflation).
Examples of deflationary assets are typically hallmarked by scarcity – things like Bitcoin and gold.
The Impact of COVID-19
COVID-19 has had an unprecedented economic effect. Unemployment claims are so bad they’re distorting historical graphs. Global travel is at a stand still. Companies are struggling with remote working capabilities. Revenue across many industries has dried up almost overnight. The jury is still out on whether these impacts are temporary (1–3 quarters) or will be long lasting (several years). So what does all of this mean for inflation and deflation?
The short answer is that it is unclear.
The case for inflation rests largely on the record amount of spending the US government has been doing to stem the economic damage of COVID-19. The trillions of dollars spent so far by the US government has been largely broken down into two categories: Fiscal Stimulus and Money Printing. Fiscal Stimulus largely means money that will flow into the real economy (think the everyday economy you interact with). The stimulus checks and Payroll Protection Program (PPP) fall under this category. Money Printing is money that flows into the banking system as new bank reserves. This money never leaves the banking system and thus its inflationary impacts are limited.
The biggest risk for inflation lies in Fiscal Stimulus. These onetime programs are necessary to the wellbeing of people across the country but should these programs be renewed or become staples of policy there will certainly be upward pressure on prices as more money enters the real economy.
The case for deflation is largely defined by reduced economic activity. COVID-19 shutdowns coupled with layoffs and quarantines have crippled demand across many industries. Economics 101 teaches us that as demand falls prices will follow in the near term until supply can adjust. You’ve probably seen an example of this phenomenon at your local gas pump.
What’s the most likely scenario? It will probably be a combination of both deflation and inflation. In the near term we will certainly see deflation. The prices of goods and services will go down as vendors try to stimulate sales in a climate where people are thinking twice about spending their dollars. In the longer term we will likely see inflation as the impacts of global quantitative easing are uncovered. It’s possible future inflation will stay near the targeted 2% rate but there also exists the possibility of inflation beyond 2%, a situation that could have dire consequences for the global monetary system.
Fund Performance to Date
In the interest of transparency we will post fund performance metrics and an allocation chart in every blog post. Mizu Capital may hold positions in the assets discussed.
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