Making a $1 today worth $2 tomorrow

Unlike it's sibling inflation, deflation doesn't make flashy headlines. It isn't the subject of hours of debate from the talking heads on CNBC.

In fact, the defacto textbook for investing (Check it out on Amazon: Investments by Bodie, Kane, and Marcus) has 12 different index entries related to inflation. How many entries does it contain for deflation? ZERO!

For the people who have heard of it, they usually think it'ss great. I mean, when is getting more for less a bad thing?

You've probably even tried to be a source of deflation, and you don't even know it. Ever haggle with a store clerk? Ever look to buy a home and point out all its flaws before making an offer? In both cases, you are trying to deflate the price, so you can get more with less.

If your low-ball offer is accepted, then congratulations! You've just caused deflation. But as great as that sounds, it is not always the best thing since sliced bread.

What is Deflation

Deflation is defined as the sustained or gradual decrease in general prices. Prices will naturally fluctuate over time, but a consistent decrease is an indicator of deflation.

Here are some simple examples showing when it's good, manageable, and bad.

3% deflation is good when...

  • You want to buy a $100 watch. You wait one year, and the $100 watch is now 3% lower ($97).

3% deflation is manageable when...

  • You can't decide what watch to buy, so you invest your $100 at a 3% return. After 1 year, your "value" of your investment is still $100 ($100+($100*(3%-3%)), and you can buy the same watch for $97.

3% deflation is bad when...

  • You own a $100 watch. After 1 year, your watch is worth $97.

Using these simple examples gives you a powerful rule of thumb:

Deflation is good when you're looking to buy and bad after you've bought.

The Impact of Deflation

Falling prices are great when you're looking to buy, as mentioned above. But companies don't make profits when they have to sell cheaper goods and services.

In order to stay profitable, companies cut costs. At first, they'll try to lower production volumes, which means they will make less product to sell. When production is lower, fewer employees are needed to oversee the operations and lay-offs follow.

Some experts argue that falling prices also mean falling costs, because businesses can buy raw materials at a lower price, and those cost savings to the company on the input side can offset the lower selling prices on the output side. Everyone wins.

Unfortunately, there's a small problem with this logic. Labor costs (i.e. our paychecks) do not fall in a deflationary environment.

Have you ever heard of a "negative" cost of living raise? Or how about a cost of living "cut" instead of a raise? If prices are lower, then it shouldn't be a big deal because we can still buy the same amount of stuff, right? Right.

The reality is that adjusting wages downward is seen as a pay cut, regardless of what prices are doing. That's why you don't hear about them until companies only other option is layoffs. In fact, layoffs are the most common corporate strategy during deflationary periods.

And when workers are laid off, they spend less money. In order to try and motivate people to buy things, companies continue to lower prices, which leads to lower profits.

People with money have no motivation to spend it, because it becomes more valuable (i.e. you can buy more with $1 tomorrow than you can today).

Causes of Deflation

Deflation can begin very simply. Ever buy something on sale? Then you have benefited from price deflation.

When there is too much supply and not enough demand, companies lower prices in an attempt to get people to buy more stuff.

Who doesn't want to by something when it's "on sale"...think of year closeouts or Black Friday doorbusters.

What causes too much supply and not enough demand? Lack of spending. But what causes a lack of spending on a scale large enough to cause deflation on a national scale?

It all begins with something called "credit tightening". When debt is cheap, it is considered to be "loose"; there isn't much risk, and it's pretty easy to get a loan. As rates increase, it becomes harder to get a loan (i.e. credit tightening).

Now you may be asking what causes credit tightening? There are three broad things that can cause tightening.

Rising interest rates

When interest rates increase, the cost of borrowing money increases. So the amount of money a company must generate (profit) also goes up in order to repay the loan.

You can see credit tightening in action when you're thinking about getting a new car using a loan from the bank. A higher interest rate means that your monthly payment is also higher. This means there is less money left over for other things you may want to purchase during the month. You may opt to wait for a lower interest rate, and either save your money or spend it on something else. Companies are no different.

Economic Shocks

Bank failures fall into this category. In the United States, we have a credit based economy. So lending and borrowing are the core of our economy.

If banks were to fail, then so would the U.S. economy. It is this thought process that led to the term "too big to fail" during the credit crisis of the late 2000's.

If there were widespread banking failures, the U.S. would have entered a deflationary spiral, causing massive unemployment.

Price competition

This is what happens when companies enter into a "price war"...the end goal is for one of the companies to go out of business. The surviving company has no competition, and can jack up the price.

How Deflation is "Controlled"

The Federal Reserve (the Fed) can impact deflation by raising or lowering interest rates. But contrary to popular belief, the Fed cannot control deflation directly.

When the economy is doing well, inflation can become too high. The Federal Reserve raises the federal funds lending rate, which raises the interest rate on debt.

The thought is that this action will decrease the rate of inflation and/or even cause some deflation.

By raising the federal funds rate, the Federal Reserve tries to encourage businesses to take on less debt.

With a higher interest rate, the Fed hopes that people will be encouraged to save more money, thereby buying less "stuff" and saving more money.

All this leads to lower production of goods and services and less hiring, which slows economic growth.

Why is Deflation so Dangerous

There is a monetary component and a psychological component to fighting inflation.

Trying to control deflation is like playing with fire.

When fighting inflation, rates can be raised as high as needed.

When fighting deflation, rates cannot go below zero. While there is some debate about the Fed's ability to artificially create rates lower than zero, the Fed Fund rate can't go below 0.

So the closer that the Fed pushes the interest rates toward zero, the less power it has to combat inflation.

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