Saturday, February 9, 2013

What About Deflation?

The last time the U.S. experienced deflation was during the Great Depression.  Deflation is a general decline in prices caused by the reduction of credit and money supply.  In 2009 we got a little taste of deflation the average inflation rate for the year was -0.4%. During the Great Recession the housing and stock market lost about half its value; a sign of declining prices. 

The media and economists warn consumers and investors to prepare for rising inflation. Yet there are experts that believe the opposite is true claiming that the amount of debt outstanding in the world is pretty much unpayable.  Another reason why deflation should not be ignored is that the velocity of money has been slowing down.

You don't want to hold debt during a deflationary period:

If a consumer has credit card debt which he is repaying at 14.99% interest the amount of interest will rise as deflation starts accelerating making the loan more expensive.  During periods of deflation companies lower prices and that leads to lower wages. This eventually leads to default making bonds undesirable. 

If companies are lowering prices and consumers are spending less that can only mean a reduction in profits.  A reduction in profits for companies holding plenty of debt can only mean lower stock prices that is why investors should evade stocks during deflation. 

Deflation may not pose a real threat but if it does come about a smart investor does not need to fear.  Information is the true hedge!  During deflation cash is king so is gold.  Inflation eats up your money on the other hand deflation increases the value of your money risk free.  The moral of the story is don't panic during deflation.  Stay liquid my friends.

                                            U.S. Historical Inflation Rates 1929-1939


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