Recent comments by Fed chairman Bernanke indicate that the US Federal Reserve will continue its $85 Billion a month bond buying program. The cited concern is persistently low inflation. The objective of the Fed is to keep inflation above 2% as one of their concerns is economic deflation. Just what is deflation and if things go badly how does one go about investing during deflation of the US economy?
- A decrease in the general price level of goods and services
- An inflation rate less than zero
- An increase in the real value of money
- An economic circumstance in which one can buy more goods with the same quantity of money
The Problem with Deflation
During periods of deflation cash is king. Deflation makes you richer if you have money in the bank and poorer if you have extensive debt. An advantage of having a slow and steady rate of inflation is that homes and businesses become more valuable over time and the debt taken on to purchase them becomes less of an issue. The reverse happens in deflation when your home and business become cheaper in relation to cash and your debt can become overwhelming.
Investing During Deflation the US Economy
If the US economy heads into a period of deflation you want to be holding cash and you want to reduce your debt. Negative interest rates are a possibility. That is to say the bank may want to charge you for holding your money. Fundamental analysis of investments needs to take this into consideration. Companies with lots of cash will be popular as will high paying dividend stocks . Dividends will in fact need to keep up with the diminishing value of stocks as related to the value of cash.
Are We Heading into Deflation?
Historically deflation is not only possible but common. The USA had long periods of deflation during the 19 th and early 20 th centuries before the creation of the Federal Reserve. In the current day the concern is of a reduction in demand for goods and services which will lead producers and sellers to drop prices to continue sales. This happened in Japan twenty years ago and the Asian nation is just coming out of two decades of economic stagnation. The policy of the Fed regarding bond purchases is to keep interest rates down and help the economy recover. Buy pumping money into the system it also tends to increase demand for products and services. To the extent that the Fed reduces its bond purchasing stimulus program there might be a consumer and business retrenchment that could drive down prices. Businesses would compete for business on a price level and the USA could see deflation. Investing during deflation of the US economy would best be as detailed above. However, they call them economic cycles for a reason.
Into Deflation and Out Again
Anyone investing during deflation of the US economy would need to remember that the Fed would likely resume monetary policies that would drive the economy back into an inflationary trend. That means that the old blood in the streets adage could apply. Wait for things to look darkest and then use your strong dollars to buy property or stocks in preparation for an inflationary and profitable surge of the economy. A conservative approach would be to diversify your investment portfolio to cover the risk of deflation and prepare for an inflationary comeback.