The relatively low rate of inflation we’ve enjoyed now for decades is all but taken for granted.
But it shouldn’t be. Significant changes in the consumer price index and the overall rate of inflation - heading either up or down - can have a profound impact on your investments and on the economy as a whole.
In the 1970s, when inflation sometimes reached double digits, the stock market was down, unemployment was up... and the economy as a whole was not much different than it is today.
Recently, though, we have experienced deflation, which is a period when prices drop. The U.S. Labor Department reported that consumer prices fell 1.3 percent in the 12 months ending in May, which is the steepest drop since 1950.
Deflation may seem like a good thing to cash-strapped consumers, but it’s a sign that all is not well with the economy. Prices drop when the economy is so weak that consumer demand drops. When prices drop, profits decrease, stock prices drop, and unemployment and bankruptcies increase.
Consumers put off purchases and wait for prices to fall further, which contributes to even further deflation. Deflation was an issue during the Great Depression and every period of deflation has been accompanied by a recession.
Deflation has been rare since World War II, but inflation has not. Since the economic pain caused by inflation during the 1970s, the Federal Reserve Board entered into a period where its primary role was seen as controlling inflation. It has filled that role with a fair degree of success. During the 1970s, the average inflation rate was 7.09 percent, but it dropped to 5.55 percent in the 1980s, 3 percent in the 1990s and just 2.78 percent for 2000 through 2007.
So why should we be worried about inflation? Or, conversely, deflation?
The Fed’s changing role
Last year, the Fed’s role changed. As the subprime crisis evolved, the Fed put aside its focus on inflation and focused on the crisis, dropping interest rates to record low levels. In addition, oil prices spiked, contributing to an overall rate of inflation of 3.85 percent, which was the highest level of inflation since 1991, when the inflation rate hit 4.25 percent.
However, the end of 2008 and the first few months of 2009 were a deflationary period. As in the Great Depression, prices were actually falling. Prices of real estate and oil, in particular, decreased significantly. Many factors contributed to deflation and signaled that it would continue, including the stock market crash, a lack of consumer confidence in the economy, low housing starts and significant drops in industrial production and retail sales; especially auto sales.
Some believe deflation will continue, driven by factors such as a curb in spending by baby boomers as they approach retirement, and efficiencies caused by globalization and technological improvements.
Now, though, there are already a growing number of signs of inflation. Oil prices are rising again. Banks are showing signs of stabilizing, which will result in more lending; more lending will put more money into the economy. More money in the economy reduces the value of the dollar, causing prices to rise.
More worrisome, though, is the trillions of dollars being spent by the federal government on new programs and economic stimulus. The government will need to finance this spending by issuing debt in the form of U.S. Treasury bonds, by increasing the money supply or both.
With interest rates low and the economy in poor shape, foreign investors, such as China, are unlikely to have a high level of demand for U.S. Treasuries. They may, in fact, sell the bonds they hold, which will further decrease demand for the dollar.
That will mean the money supply will have to increase, which will result in current dollars being worth less, so even more money will need to be printed. The result will be a significant increase in inflation.
When inflation is high, everyone’s standard of living drops. Consumers initially may stop saving and buy more in anticipation of rising prices. Long-term, they will buy less because they can afford less. The price of doing business also increases, which has a spiraling effect on the cost of goods.
So how should investors react to potential inflation - or potential deflation?
When prices are unstable, the stock market is likely to be unstable as well. When the market is volatile, investors who follow a "buy-and-hold" investment strategy are vulnerable. Their investments will rise and fall in value along with the market - just as they have in recent years.
The best approach is to keep a close watch on price trends and to adjust investments accordingly. At times like these, it is more important than ever to be nimble and to act quickly as market conditions change.
Brenda P. Wenning is president of Wenning Investments LLC of Newton. She can be reached at Brenda@WenningInvestments.com or 617-965-0680. For additional information, visit her blog at www.WenningAdvice.com.
