Your Take: Deflation Is the Bigger Concern
Ryan Zabrowski, director of arbitrage and senior portfolio manager at Krilogy in Creve Coeur, Mo., puts inflation in perspective.
While inflation tends to get a lot more press coverage and is generally regarded by the public as the greater economic threat, inflation is generally short-lived, and the Federal Reserve has weapons it can use to help defuse it.
Deflation, on the other hand, is a far bigger, long-term problem that defies conventional remedies.
The fact that inflation occurs much more frequently than deflation is one reason it gets more media exposure and congressional attention. When inflation is extreme, such as it has been since November 2020, the threat of deflation seems remote and hardly worth consideration. But the danger of deflation, although seemingly remote, never really disappears. And the fact that the Fed has so few options for effectively combatting it makes it a more menacing threat.
Deflation occurs when declining prices, typically the result of a drop in demand and spending, become so severe that producers must continually cut prices to attract buyers. Deflation creates incentives for consumers to postpone spending and wait for a future time when they expect prices will be lower and their purchasing power greater. This weakens the economy. Deflation’s unseen peril is that it creates a public expectation that prices will continue to plunge indefinitely.
If you believe the price of that new car will be substantially lower in six months or a year, you are likely to delay the purchase, hoping for a better deal, unless you are forced to buy right now. This expectation tends to spread to all nonessential purchases, from automobiles to housing.
Inflation and deflation share a common element that both feeds and prolongs the economic distress: public expectations.
Expectations drive behavior. If people believe a severe snowstorm is coming, they rush to buy batteries and bottled water. If people hear that real estate prices are dropping, they delay new home purchases, hoping for a bargain. When enough people adopt the same expectation, it becomes a self-fulfilling prophecy.
Expectations can prevent people from gaining knowledge. Most people do not understand the concept of free-flowing capitalism and how continuous scientific advances are creating massive, if camouflaged, deflation. As a society, we have an ongoing deflationary challenge that’s a problem not just for the U.S. but for governments around the world.
The dilemma stems from deflationary forces such as the scientific and medical advances that now allow people to live longer. As the average lifespan increases, the attendant social and economic costs are exacerbated. The dynamic is skewing labor force participation metrics, health care expenditures and Social Security finances.
Another deflationary factor is access to and advancement in computer technology. Information that previously took hours or days to retrieve from libraries can now be secured in seconds from the Internet, resulting in enormous time savings and productivity gains. The resulting ability to do more with less defines our faculty to leverage technology. Some 40 years ago, the CRAY-2 supercomputer was the fastest and most powerful machine ever built. Compare that to today’s smartphones, which are about 5,000 times faster than the CRAY-2 and have democratized technology for people worldwide.
Deflation creates a vicious cycle. Consumers delay purchases which depletes corporate profits which in turn prompts companies to reduce their workforce to cut costs and maintain profits. Unemployment rises, banks get nervous about outstanding loans and restrict lending. Potential borrowers have less money to spend, which causes corporate profits to retreat further.
Meanwhile, the banks boost borrowing costs to offset potential losses causing corporations to lay more people off. This cycle is a particularly virulent one that is difficult for the Fed to quash once it gets started. The only ammunition they have in their limited arsenal is to flood the market with money and maintain near-zero interest rates, as they did in response to the great recession and pandemic. Firing those bullets, however, usually results in a devalued currency, as Japan discovered when their currency reached a 32-year low against the dollar in 2022.
Do you have an opinion that you want ot share with other member of the financial planning community? We encourage financial professionals to send us their ideas for a Your Take column to us at [email protected].