Is Inflation Really Dead?

The biggest financial threat that most investors face is the effect of inflation on purchasing power. Yet lately, most signs of inflation have just about disappeared. Is the threat of inflation finally behind us, or are investors ignoring inflation to their peril at the worst possible moment?

Why inflation matters
Millions of conservative investors happily put their money in low-yielding bank accounts and fixed-income securities, secure in the belief that they're investing safely. Yet the apparent stability in the nominal value of their investments hides the fact that their money won't be able to buy nearly as much in goods and services in the future as it did in the past.

In recent years, though, investors have discounted the potential impact of inflation on their portfolios. Consider these facts:

  • Gold is the traditional safe-haven investment for those who believe that inflation will take away the purchasing power of paper currency. Yet the plunge in gold prices has led to a mass exodus of investor interest in gold, with the popular SPDR Gold Trust (NYSEMKT: GLD  ) losing billions of dollars not just due to price declines but also as investors have taken money out of the ETF entirely.
  • Inflation-indexed bonds like the Treasury's TIPS have climbed so far in price that their real inflation-adjusted yields are negative, even for bonds that don't mature for another 20 years. That's been excellent news for existing investors in iShares Barclays TIPS Bond (NYSEMKT: TIP  ) and similar inflation-indexed bond investments, but it presents no inflation protection for those considering purchases now.
  • The sole fly in the inflation ointment has come from energy prices, with gasoline and heating-oil prices having remained stubbornly high despite plentiful domestic production from unconventional plays as refiners Phillips 66 (NYSE: PSX  ) , Valero (NYSE: VLO  ) , and others have greatly boosted their exports of refined products rather than letting Americans reap the benefits of high supply. Yet even the oil market has seen international spreads narrow, and gasoline prices have finally started to come down modestly, providing further downward pressure on inflation.

Based on the conventional understanding of inflation, you'd think that all these signs of its demise were a good thing. The truth is far less clear.

The perils of deflation
The main problem with killing inflation is that you potentially have to deal with the alternative. For years, the Federal Reserve has seen deflation as an even bigger threat, as it often leads to a downward spiral in economic activity.

We've already seen the impact of deflation on the PC industry. Admittedly, PC makers have suffered at the hands of more innovative mobile devices that consumers prefer over bulky, unwieldy old-fashioned personal computers. But another contributing factor to the decline of the PC is the fact that buyers have always been rewarded for putting off technology purchases, as first adopters inevitably pay a huge premium for cutting-edge devices, only to see that premium quickly erode. The incentive to procrastinate depresses PC sales, as value-conscious consumers learn to buy only when they absolutely need better technology.

When deflation hits the entire economy, this phenomenon encourages people to put off buying anything, as their purchasing power will increase the longer they wait. Moreover, while those who have net savings benefit greatly, deflation wreaks havoc on leverage-rich economies, making it increasingly difficult to come up with fixed payments to repay debt.

Be careful what you wish for
In the end, the most important question may not be whether inflation is dead but rather whether we should want inflation to be dead. With striking the right balance remaining a constant challenge, the dangers of overshooting toward the deflationary side may be worse than the ravages of inflation.

The best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

Read/Post Comments (0) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2403501, ~/Articles/ArticleHandler.aspx, 10/27/2016 6:53:47 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated Moments ago Sponsored by:
DOW 18,169.68 -29.65 -0.16%
S&P 500 2,133.04 -6.39 -0.30%
NASD 5,215.97 -34.29 -0.65%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

10/27/2016 4:00 PM
GLD $121.01 Up +0.22 +0.18%
SPDR Gold Trust CAPS Rating: **
TIP $115.51 Down -0.50 -0.43%
iShares Barclays T… CAPS Rating: *
VLO $58.81 Down -0.71 -1.19%
Valero Energy CAPS Rating: ****