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 (GLD 0.23%) 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 (TIP +0.17%) 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 (PSX 1.95%), Valero (VLO 3.91%), 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.
