Global Deflation Risks—What it Means for Investors (part 1 of 2)

By Brian Dolan, Head Market Strategist

 

The Looming Specter of Deflation

More than a dozen major central banks have cut rates so far this year, with Sweden’s Rijksbank unexpectedly joining the crowd just yesterday.  Many have cut benchmark rates to zero or even into negative territory, while some have also announced massive asset purchase programs, such as the European Central Bank (ECB) and Sweden. The moves are partly intended to stimulate flagging or recessionary economies by lowering borrowing costs further and hopefully stimulating demand. The real focus, though, is on heading off a potentially vicious spiral of deflation.

Deflation refers to an environment where the costs of goods and services are declining; the opposite of inflation.  You may be thinking, why is it such a bad thing if prices fall? Lower prices mean consumers have more disposable income, which should be good for spending and saving, right? The answer is:  it depends on how long deflationary conditions persist.

Deflationary Spiral

The fear that keeps central bankers awake at night, and what prompted these recent extraordinary measures, is that if deflation continues for an extended period, expectations of future deflation may become entrenched.  That mindset can lead businesses and consumers to hold off on investing and spending now, and instead wait for lower prices in the future. That creates a vicious cycle of lower spending and investing, leading to lower demand and stagnating wages and growth, which leads to further deflation, lower spending and investing, and so on and so on. Inflation is relatively easily managed by central bankers—they keep raising interest rates until inflation is brought back under control. Deflation is a much more complicated and difficult hole to climb out of. Just look at Japan, which has been struggling to break a cycle of deflation for nearly two decades.

That’s the reason behind the extraordinary measures and sense of urgency of recent central bank policy moves. They’re trying to show markets that they’re serious about avoiding the deflation trap. For now, they’re all expressing confidence that they’ll be successful in returning inflation to their mandate targets.  Unfortunately, most are only forecasting a return to their price objectives (around 2% CPI) in about two years, which is plenty of time for deflationary expectations to set in. Even positive, but persistently low inflation rates (‘low-flation’) can trigger a downward spiral in long-term inflation expectations, potentially leading to the same vicious economic cycle as outright deflation.

US May Escape Deflation

The deflationary landscape is more pronounced in some regions than others. Most notably, Europe and Japan have recently posted outright monthly declines in prices, while the US and China are registering low real inflation readings of around 1.2-1.5% annually. US Fed policy makers are confident the US will avoid deflation, but the risks are skewed in that direction, and even low-flation may be enough to stall the US recovery.

The biggest risks to the US outlook are from weakness overseas hurting demand globally and restraining US growth. The strength of the US dollar also puts downward pressure on US inflation. Investors will need to keep a close eye on US inflation rates and any signs of spillover from weakness abroad manifesting itself in weaker US spending data.

It remains to be seen whether the policy steps by the ECB and other European central banks will be effective and when, as it usually takes around six months for interest rate policy changes to be reflected in the economy. In the meantime, the global investment environment will remain in the shadow of the specter of deflation.

Next up:  Part 2—Strategies for Investors in a Deflationary Environment