Most people love to go on a rant about how bad inflation is. Deep down we just hate not being able to buy a particular good or service for what we bought it for just a few years ago. Of course, we never complain about the things that haven’t gone up in price or those that have dropped in price. Our focus tends to be on the items that negatively impact our wallet – a very human perspective.
According to the inflation statistics generated by the Bureau of Labor Statistics, inflation as measured by the Consumer Price Index (CPI) has been muted for the last several years and currently is sunning at a rate of about 2 percent. The CPI is calculated as a basket of goods and services commonly purchased by households included in a group defined as “all urban consumers” which represents about 87 percent of the U.S. population.
All agree that categories such as medical care and education have been rising at high rates for quite a long time. However, some goods haven’t gone up for a while or may have gone down in price. For example, a gallon of gas costs about $3.30 today, but 6 to 7 years ago it was well over $4.. So, we’ve seen deflation in the price of gasoline over the last seven years.
The price of flat screen TVs is another area where major deflation has taken place. My first flat screen, a 42-inch Sony purchased in 2005 cost about $2,400. I recently purchased a 55-inch smart, flat screen TV, which allows me to surf the Internet, check my e-mail, download Netflix movies, etc. for about $850.
The key part of my TV story on the inflation impact to the CPI isn’t just the price drop of about 60 percent in TVs over eight years, but the fact that I got so much more for each dollar spent. The larger more powerful TV provides a lot more entertainment value than my original Sony. Getting more for your money is factored into the CPI calculation and shows up as deflation even if the price stayed flat.
We could debate all day on whether the methods used to calculate inflation figures are correct, but once we get a handle on the basic concept, the important part is to understand the impact inflation or deflation may have on the financial markets, our spending power, etc.
In a capitalistic society like ours, a moderate amount of inflation is desirable. Low to moderate inflation causes asset values to go up, creating an environment favorable for savings and investment. The last five years are a good example of this. Low inflation allows for low interest rates where businesses can invest for the future, creating jobs which lead to economic expansion in a virtuous cycle that can last for years.
If growth accelerates to a high level, then demand for goods and services exceeds supply. Inflation can accelerate to unacceptable levels that threaten the currency base, and monetary authorities step in to raise interest rates to moderate economic growth to prevent rampant price increases. Sounds pretty easy, but in fact it is not. Once inflationary trends become embedded they can be hard to pull from the system.
The last significant period of high inflation here in the U.S. was the 1970s to the early 1980s, which was exacerbated by the Arab oil embargoes. It took the Federal Reserve raising short- term interest rates to 19 percent in late 1981 to break the cycle of inflation, but it still took years for inflation to return to normal levels.
As scary as inflation is, the real economic evil is deflation. Deflation provides a disincentive for consumers to spend (everything will be cheaper if you wait) and for businesses to invest or create jobs (because no one is going to buy our products). Investors lose too because during deflationary periods interest rates will drop to very low levels. The excess savings from not shopping doesn’t earn anything, and stock markets are likely to fall since sales and profits of companies will be dropping. It is a no-win situation which is a hard cycle to break out of.
The most recent example of a deflationary cycle is Japan. The collapse of Japan’s stock market and real estate bubble in 1990 began a major recession and deflationary cycle. Interest rates declined to very low levels where they remain today. There are just now signs of hope emerging after 24 years. By the way, Japan’s Nikkei stock market index is currently at about 15,900, still down 60 percent from its 1990 peak. If you wonder which is worse, moderate inflation or deflation, I suggest talking to your peers in Japan who’ve experienced a 20+ year recession.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing. Visit www.breitercapital.com.