In the world of economics, there are two fundamental terms used to describe the price movements 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 investments too.
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 U.S. Bureau of Labor Statistics. Finally, we'll briefly describe some of the best investment options available to leverage these economic states.
Inflation and Deflation Defined
In economics, there are two ways to describe the changes in the prices of goods and services over time:
Economists generally favor a low and steady rate of inflation. The job of keeping inflation under control is assigned to the monetary authorities at the Federal Reserve. Increases and decreases to the money supply can be used to regulate the growth of the economy. The levers used to control the money supply include interest rates, buying and selling of government securities (Open Market Operations), and bank reserve requirements.
The relationship between interest rates and inflation is relatively straightforward. If the economy is expanding too quickly, the Reserve can lower the money supply by raising interest rates. Higher interest rates discourage borrowing, which lowers the money supply. To increase growth, the Reserve can lower interest rates, thereby encouraging borrowing. The Federal Reserve controls interest rates through the Discount Rate, which is the rate that banks are charged when they borrow money from the Federal Reserve.
Open Market Operations
The Federal Reserve, along with the Central Bank, can also 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
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 slow down the economy, 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.
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 this continues, a country's monetary system can collapse. That is to say, the country's money becomes nearly worthless.
In the United States, the most common 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 economic trends including:
Traditionally, investing in gold was a hedge used by investors to insulate themselves from inflation. But in late 2012, gold was selling for nearly $1,700 an ounce, which may not be a good choice for many investors. In addition to gold, the following investments offer protection from inflation:
When deflation occurs, the prices of goods and services are decreasing, so the primary goal for investors during these 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 practical option. If the Federal Reserve lowers interest rates, 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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