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 In the world of economics, there are two fundamental terms used to describe the prices of goods and services over time - inflation and deflation. As investors, it's important to understand the impact inflationary or deflationary times can have on our return on investments.
In this publication, we're going to start by defining the two macroeconomic terms inflation and deflation. Next, we'll talk about how these conditions are measured by the US Bureau of Labor Statistics. Finally, we'll briefly describe some of the best investment options for beating either inflation or deflation.
Inflation and Deflation Defined
In economics we learn there are two ways to describe the changes in the prices of goods and services over time:
- Inflation - a consistent increase in the prices of goods and services over time is known as inflation. During inflationary times, money loses its "buying" or "purchasing" power, and it takes more units of currency to purchase the same units of goods or services. Over time, inflation lowers the value of each unit of currency.
- Deflation - a consistent decrease in the prices of goods and services over time is known as deflation. During deflationary times, money increases in its "buying" or "purchasing" power, and it takes less units of currency to purchase the same units of goods or services. Over time, deflation increases the value of each unit of currency.
Controlling Inflation
Economists generally favor a low and steady rate of inflation. The job of keeping inflation low is assigned to the monetary authorities at the Federal Reserve. Inflation can be controlled by increasing or decreasing the money supply. The levers used to control the money supply include interest rates, buying and selling of government securities (Open Market Operations), and bank reserve requirements.
Interest Rates and Inflation
The relationship between interest rates and inflation is relatively straightforward. If inflation is too high, the Reserve can lower the money supply by raising interest rates. Higher interest rates discourage borrowing, and that lowers the money supply. Conversely, to fight deflation the Reserve can lower interest rates, thereby encouraging borrowing. The Federal Reserve controls interest rates via the Discount Rate, which is the interest rate that banks are charged when they borrow money from the Federal Reserve.
Open Market Operations and Inflation
The Federal Reserve, through its interactions with the Central Bank, can control the money supply through the buying and selling of government securities (bonds). When the Central Bank buys securities, it is exchanging money for the security. Therefore, when the Central Bank wants to lower inflation, it can sell government securities and decrease the supply of money. Conversely, when the Central Bank wants to fight deflation, it can buy government securities.
Bank Reserve Requirements and Inflation
While arguably the most effective tool the Federal Reserve can use to control inflation, changing the reserve requirement is rarely used by those in charge of establishing monetary policy. The reserve requirement is the money a bank needs to keep in Federal Reserve vaults. The requirement is a fixed percentage of the customer deposits held at each depository institution or bank.
When the Federal Reserve wants to lower inflation, they can increase the reserve requirement, thereby decreasing the supply of money. Conversely, when the Central Bank wants to fight deflation, it can decrease the reserve requirement.
Hyperinflation
When inflation is out of control, it's possible for prices to increase by several hundred percent per month. Generally, the term hyperinflation is used when prices increase in excess of 50% per month. If hyperinflation continues, a country's monetary system can collapse. That is to say the country's money becomes nearly worthless.
Measuring Inflation
In the United States, the most famous measure of inflation is the Consumer Price Index. At a slightly more granular level, the Bureau of Labor Statistics publishes several other measures aimed at identifying domestic inflationary trends including:
- Consumer Price Index (CPI) - this program monitors monthly changes in the prices paid by urban consumers for a "basket" of goods and services. This basket includes food, clothing, shelter, fuels, transportation fares, doctor and dental services, and prescription medications. The CPI is used by a wide variety of organizations to adjust wages, rents, and other items affected by a change in the cost of living.
- Producer Price Indexes (PPI) - a family of indexes aimed at measuring the change in the selling prices received by domestic producers of goods and services. At one time, these were known as the Wholesale Price Indexes, and the measure is a good indication of the cost to produce goods and services.
- Employment Cost Trends (ECT) - also referred to as the National Compensation Survey, this program publishes quarterly indexes that track labor costs, overtime rates, wages, salaries, as well as the cost to supply benefits to employees.
Investing to Beat Inflation
Traditionally, investing in gold was a hedge used by investors looking to insulate themselves from inflation. But in late 2009, gold was selling for more than $1,200 an ounce, and at that price gold may not be a good choice for investors. In addition to gold, the following investments offer protection from inflation:
- Treasury Inflation Protected Securities (TIPS) - inflation index bonds issued by the United States government, the principal on these bonds are adjusted using the Consumer Price Index. The coupon rate on the bonds remains constant, so as the principal increases or decreases, the bond yield would decrease or increase.
- I Bonds - United States Savings Bonds with a fixed face value, but a yield that varies with inflation. The interest rate on these bonds is made up of two components - a fixed rate that earns interest monthly plus an inflation adjustment that occurs every six months.
- Corporate Inflation Linked Bonds - a corporate security that adjusts each month for changes in the Consumer Price Index.
- Inflation-Protected Annuities (IPA) - these are annuities that increase their payout each year based on a measure of inflation or a percentage chosen by the investor. If the investor chooses a relatively high increase each year, then the starting payouts for the annuity will be lower.
Investing to Beat Deflation
When deflation occurs, the prices of goods and services are decreasing, so the primary goal for investors during deflationary times is to hold cash since its relative value is increasing. One approach to holding cash includes placing money in money market funds or short term treasury bonds.
Corporate bonds paying a fixed rate of interest is another example of a good investment when deflation occurs. Remember, one of the ways the Federal Reserve can deal with deflation is to lower interest rates. When interest rates decrease, the value of a fixed rate bond will increase.
Finally, in the same way investors traditionally held gold as a hedge against inflation, it's a bad idea to buy gold when deflation is at hand.
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