OfflineThe question of whether we are seeing deflation or not appears in much of the west and Florida as well deflation re-defined.
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Could Japanese-style deflation happen here? And if so, what would it mean for you and your money? Can you prepare in case it hits?
Let's take these in turn.
Is Deflation a Risk?
You'll hear plenty of voices on Wall Street telling you there's no serious chance of deflation. Trouble is, they have a terrible track record of predicting these big, paradigm shifts. Over the past decade, few predicted the bear market, the housing collapse or the financial crisis. Their assurances need to be taken with a fistful of salt.
Indeed, depending on how you measure it, deflation may already be here. According to the Department of Labor, consumer prices have been flat over the past three months. Hourly wages fell 0.7% from the first to second quarter. Those in manufacturing fell nearly 2%.
Housing, the most important asset by far to most people, has been in steep deflation for years.
Our chart below shows the median inflation index produced by the Federal Reserve Bank of Cleveland. At least by this measure underlying inflation has now collapsed to dangerously near zero.
Naturally the future is unknowable. We may well dodge the bullet. Fed chairman Ben Bernanke has already vowed to do everything he can to prevent a deflationary spiral from developing.
But one would scarcely want to ignore the danger completely.
In deflation, prices and wages fall. Japan has suffered this since the mid-1990s. The U.S. suffered it severely in the early stages of the Great Depression. Periods of deflation were more common before the First World War, when most of the world had currencies pegged to gold.
If It Happens, What Does It Mean for Your Money?
David Rosenberg, the chief economist at Gluskin Sheff in Toronto, puts it best. In deflation, cash wouldn't be king. Income would be king.
Investors would be struggling to find safe, dependable sources of income.
So top-quality bonds, which provide that income, would boom. Bond prices would rise, and the yield, or interest rate, falls. (In Japan, at one point, long-term government bonds yielded nearly nothing).
That would be good for Treasurys, especially longer-term bonds, as well as for better quality municipals and corporates.
Cash would still be prince, though. If a savings account earns you zero percent interest, but prices fall 2%, you've still made 2% in real terms. And it's tax free. (Contrast that with earning 4% interest in an era of 2% inflation).
Gold would probably benefit. If deflation hits, Mr. Bernanke will set world records for printing money to stave it off. Logic says that would help gold, which can claim to be a monetary asset of limited supply.
Most analysts will tell you deflation is typically terrible for the stock market. Look at Japan over the last two decades, where the market has plummeted by about three quarters. Look at Wall Street in the early 1930s, which collapsed by about nine-tenths. Deflation hurts stocks because companies see their prices collapse faster than costs. Where companies are also leveraged, they also suffer because their debts don't deflate with everything else.
Not all stocks need suffer. A few years ago James Montier, a former strategist at SG Securities in London (and now working for Boston's Jeremy Grantham at GMO), looked at what investment strategies actually worked in Tokyo after 1990. He found that most of the stock market's slump came from the sinking of the overpriced "glamour" stocks–in this case, the country's big banks. Meanwhile many underpriced, good quality, so-called "value" stocks actually fared much better. Mr. Montier concluded that a Japanese investor who had invested in the value stocks, and shorted, or bet against, the glamour stocks could have made good money even through those two decades–even in the midst of deflation and a terrible bear market.
If income would be king and cash would be prince, in an era of deflation, debt would be the devil.
Your credit card bill. Your car and student loans. Your mortgage. As incomes and prices fall, the bills stay the same, which means they grow in real terms. It gets harder and harder to pay them off. "You're paying down debts but your income is falling," says SG strategist Albert Edwards. "So you have to pay down your debt even more quickly. You get into a vicious cycle."
Naturally what makes this even harder is that everyone else is trying to do the same. The economy struggles to get out of a downward spiral. Company cutbacks keep unemployment high. Japan has been in and out of recession over the past two decades. House prices have sunk for most of that time.
What Can You Do To Prepare
Making wholesale changes to your finances based on the assumption that deflation is coming would probably be a mistake. It's not certain. And if the economy recovers instead you may be invested in exactly the wrong things.
Anyone thinking of loading up with Treasury bonds needs to be aware that their price has already risen a long way. The yield on the 30-year bond is a mere 3.8%. That will prove a great deal if deflation develops, but you'll get your fingers slammed in the door if the economy recovers instead and inflation perks up.
Top-quality corporate bonds and municipals may offer somewhat more value, but they, too, are looking pricey.
There are steps you can take that will help in all circumstances.
Paying off your debts as fast as possible is the most obvious. It's a no lose. One exception might be the mortgage, because of the tax break, but even there the picture is no longer so clear.
Take a look at your stock portfolio. If you are carrying a lot of equities, especially those in "glamour" stocks, be aware that in many cases they are offering an asymmetric risk: The downside probably outweighs the upside. Ask yourself if your personal finances could survive a 30% drop in your portfolio. If not, scale back, or move more money into blue chips.
And consider buying some insurance. For the sophisticated, that might include buying out of the money "put" options on the Standard & Poor's 500 index. Those are like long-odds bets on a crash. They'll pay off big in a crash, without risking too much money.
For mainstream investors Treasury Inflation-Protected Securities, so-called TIPS bonds, will work out OK in deflation or inflation, or anything in between. They aren't great value at the moment. The 30-year TIPS bond yields 1.8% above inflation. Typically, you're better off trying to buy them when this "real" yield is well above 2%. At these levels, they won't make you rich, but they won't make you poor either.
Write to Brett Arends at [email protected]
This article can be found at: http://abcnews.go.com/Business/wirestory?id=11534981&page=2
NEW YORK (Reuters) - The Federal Reserve should only embark upon further monetary easing if faced with a dangerous downward price spiral, otherwise it risks undermining its credibility, a top Fed official said on Wednesday.
Philadelphia Federal Reserve Bank President Charles Plosser, who said he does not see a deflation risk at this time, warned that more monetary stimulus would not be effective in tackling a "difficult and unpleasant" unemployment problem.
"Moving around the interest rate on long term bonds by 10 or 20 or 30 basis points is not going to solve the unemployment problems and it is dangerous to think that it will," Plosser told Reuters in an interview.
If the Fed were to send a signal that it is trying to control the unemployment rate and then fails to do so, it could hurt its ability to act to ensure price stability, he said.
"If we do need to act, if fears of deflation were to become real -- and I don't think that is the risk -- then we would need every ounce of credibility we can muster to convince markets we are not going to let deflation happen," Plosser said.
The U.S. central bank is charged by Congress to pursue both price stability and full employment.
Plosser, who rotates into a voting spot on the Fed's policy panel next year, said the economy has hit a soft patch but he still sees 2010 economic growth around 3 percent, with growth in 2011 between 3 percent and 3.5 percent.
"We're all disappointed that the economy is not doing as well as we'd like for it to do ... but the basis for a continued moderate recovery is more or less still in place," he said. "I don't really see a double-dip (recession) at this point."
A number of events over the past few months had sent some "confusing signals" about the economy, he said, making it difficult for policy-makers to read the underlying trends. These include financial market skittishness over the European debt crisis, the expiration of a housing tax credit and the impact of census-related hiring and firing, he said.
"The temptation for everybody is to want it to be over today, or next month, or next quarter but that's not something that's in fact feasible. We have to continue to acknowledge that this is going to be a slog," Plosser said.
"There is nothing the Fed can do in my book that could really change the path of the unemployment rate between now and the end of the year."
LATEST FED MOVE TO HAVE MINIMAL IMPACT
Plosser said the Fed's August 10 decision to buy Treasuries to stop its securities portfolio from shrinking and tightening monetary conditions as maturing mortgage-related debt rolls off is unlikely to have a "measurable impact" on the economy.
Plosser, who is considered one of the more hawkish Fed officials on inflation, said he would be open to further bond purchases if he saw deflation as a real risk.
"I would certainly entertain the solution if I feared deflation, which I don't, and I feared expectations were coming unglued in that direction, then we would have to take actions," he said.
But he warned that it was dangerous to view monetary policy as "a magic elixir" and said fiscal authorities are better placed to deal with long-term unemployment issues, such as skills mismatches.
The Fed has already gone to extraordinary lengths to support an economy reeling from the worst financial crisis since the Great Depression.
It cut benchmark interest rates to the bone and bought around $1.4 trillion of mortgage-related debt and $300 billion of longer-term Treasuries to further push down borrowing costs.
Plosser sees neither a near-term risk of inflation or deflation, though he worries about the impact of the Fed's accommodative monetary policy on inflation down the road.
"It's like a doctor administering medicine to a patient, if you don't get the disease right, you'll give them the wrong medicine and the wrong medicine can actually make them sicker," he said.
Copyright 2010 Reuters News Service. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.
Great Info and Advice............Thank You Ever So Much!!!!
JJD