Is deflation the new inflation?

If anyone harboured any lingering doubts about how tough next year will be, this week’s sales figures from the John Lewis department store group and a collapse in the inflation rate will have dispelled them. The 14% drop in John Lewis sales was the third double digit weekly decline in four weeks while the unexpectedly large decline in consumer price index inflation from 5.2% to 4.5% in October showed that inflation is rapidly becoming yesterday’s problem.

Food and energy costs were the main drivers of slowing price growth and with the oil price down nearly two thirds from its summer peak, lower wholesale gas prices and utility bills will add to the downward pressure. Service sector inflation is expected to fall sharply as a weakening labour market and slowing demand squeeze margins.

As a result, inflation could be well under the Bank of England’s 2% target by the end of next year, economists predict, a faster decline than even the Bank’s gloomy assessment in its recent quarterly inflation report. A fall in the retail price index next year would be the first for nearly 40 years and raises the spectre of an unfamiliar threat - deflation.

The renewed possibility of deflation represents a sea change for those of us who have been brought up to view inflation as the bogeyman. Ever since the soaring cost of the Vietnam War forced America to break the link between the amount of money in circulation and its gold reserves, economic policy has had one over-arching goal – to keep a lid on rising prices. Within six months, that orthodoxy has been abandoned.

If we are really fighting a new enemy, we should learn something about it. What is deflation? Why is it such a bad thing? And what might it mean for investors?

Why should we worry about deflation?

Deflation is a persistent decline in the general price level, not just a reduction in the relative prices of some goods or services, which can be a symptom of greater productivity or a benefit of globalisation.

But why is that a bad thing? Having become used to worrying about the insidious effect of rising prices, surely falling prices are desirable. A commodity-led decline in prices should boost consumers’ real incomes and widen some companies’ margins.

In the short term this is true, but the trouble with persistently falling prices is that they create three deadly side-effects. The first is that consumers put off spending because they believe that goods and services will be cheaper in the future. This reduces overall demand and can drive an already weak economy further onto the ropes.

Secondly, the real level of debt in the economy rises. Borrowings such as mortgages are fixed nominal amounts, so if wages decline they become more difficult to service and ultimately pay down. This process, which is called “debt deflation”, increases bankruptcy risk and makes banks even less willing to lend than they already are.

Thirdly, real (inflation-adjusted) interest rates rise because bank and commercial interest rates cannot fall below zero and are, therefore, higher than the (negative) inflation rate. As deflation becomes more entrenched, the squeeze on the economy becomes even greater.

If, as in the UK, you enter deflation with historically high levels of personal and housing-related debt, the problem is potentially even more intractable.

What can be done?

Deflation is hard to control because it can mean the usual levers of monetary policy are no longer available or do not work. A slow or inadequate policy response can mean countries end up like Japan, taking consumers to water but being unable to make them drink. In the words of economist John Maynard Keynes, they are “pushing on a string”, unable to persuade reluctant consumers to spend, however cheap they make the cost of borrowing.

Fortunately, no-one understands the seriousness of the deflationary threat better than the chairman of the Federal Reserve. Ben Bernanke is one of the world’s leading authorities on the Great Depression and the ways in which a similar slump can be averted. In fact in 2002 he gave a particularly prescient speech, titled - Deflation: Making Sure It Doesn’t Happen Here.

His proposals included printing money to bail out failing banks, buying troubled assets such as mortgage-backed securities and, if necessary, printing more money to pay directly for tax cuts. The speech earned him the nick-name Helicopter Ben (because in the final analysis governments can simply drop money from the air) but no-one’s laughing now because many of his ideas are actually being enacted.

What are the implications for investors?

A deflationary environment – more specifically the reflationary action taken to prevent it – is in theory good for bonds. Lower interest rates increase the attraction of a fixed income as anyone with money on deposit is finding out. In practice it’s more complicated than this because more companies default on their debt obligations during recessions and investors demand a higher return to compensate for the risk that they won’t get paid. Bonds can look cheap but get cheaper.

Other asset classes tend to underperform in this part of the cycle. Pressure on corporate earnings makes equities less attractive, lower demand reduces the prices of commodities and property suffers from falling tenant demand as unemployment rises and banks ration lending.

The biggest challenge for investors is the uncertainty about whether and when deflation will respond to government action and swing back into inflation again. The measures necessary to tackle a deflationary slump are difficult to calibrate so there is a real risk that policy-makers over-react and either over-stimulate the economy or create an excessive tax burden for future generations.

With so much uncertainty about how different asset classes will respond to a sharp fall in inflation, many investors will find a balanced fund is the safest haven. It will limit their exposure to any further decline in any one asset class and allow them to benefit if there is an unexpected spike in another due to the drive to reflate the economy.

Above all, investors will hope that the lessons of earlier deflationary slumps have really been learned. No-one wants to look back fondly on the good old days of inflation.

Please note the value of investments can go down as well as up so you may get less than you invested. The ideas and conclusions in Tom Stevenson’s weekly column are his own and do not necessarily reflect the views of Fidelity’s portfolio managers. They are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.

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