Everyone likes when things get cheaper because their money can buy more. Everyone, that is, except for central banks, which will do anything to prevent what’s called deflation.
Deflation is a fact of life in Japan. And, increasingly, it’s a risk elsewhere in Asia. The graph below shows the trend of declining inflation throughout Asia, including Singapore, where prices actually fell in 2015.
Most people know that “inflation” means the prices of goods and services increase. The price of gasoline, food, housing, medical care and education have gone through periods of sharp rises in recent years. In those times, consumers either have to get by with less or hope their incomes rise to keep pace. Governments don’t like a lot of inflation because citizens (that is, voters) feel poorer if inflation is too high. Thus, some central banks set an inflation “target” that they aim for.
Inflation’s evil twin doesn’t visit as often. Deflation is when the prices of goods and services fall for an extended period. It was a major problem during the Great Depression in the U.S. More recently, the sharp drop in the price of oil is good because it means people have to spend less on energy. But, it also makes deflation a greater possibility.
Japan has fought deflation for a long time. The Bank of Japan announced late last week that it would start charging commercial banks to deposit excess reserves – that is, cash – with the central bank.
Most of the time, a person who borrows money has to pay back the sum he borrows, plus a rate of interest for borrowing it. But now in Japan (and in several European countries), banks will actually losemoney by depositing cash with the central bank. When interest rates are negative, the lender has to pay interest, not the borrower.
Why is Japan doing this? The Japanese economy has hardly grown for decades. The central bank thinks part of the reason is that the country’s commercial banks are scared to lend. So they prefer to hold cash, rather than risk lending it. The problem is made worse with deflation. Banks often lend less, since borrowing money makes less sense if a loan has to be repaid with money that is worth more than it was when the loan was made.
By charging commercial banks to hold part of their cash, the Bank of Japan wants to force commercial banks to make loans instead. Lending is key to a growing economy – people borrow money to invest and to make more money.
Deflation is not widespread yet. But, if Japan’s economic problems spread and Europe starts to take more extreme measures to boost its economy, deflation might affect a lot more people.
Investors should understand these things about deflation:
- Cash is king: With deflation, goods and hard assets decrease in value, so material things become a poor investment. But, cash or money-market accounts are good places to park wealth during serious deflation. That’s because you can buy increasingly more stuff with the cash later, after the prices of food, gasoline, equipment and other goods decline. Consumers often hoard cash during deflationary times, and delay buying big-ticket items such as cars and houses. If people think things are going to be cheaper, they will wait to buy them. That causes a ripple effect in an economy as businesses cut spending on new equipment and projects. This in turn leads to increased unemployment and an economic slowdown.
- Long-term U.S. bonds may be a safe haven. If the global economy slides into deflation, high-quality bonds like U.S. Treasuries and highly rated corporate and municipal bonds will likely do well. Fearing a deflationary recession, the U.S. central bank (the Federal Reserve) likely would end its plan to raise rates from historically low levels, resulting in lower Treasury bond yields and higher prices. Also, if global deflation gets bad, U.S. Treasuries will attract more money as investors seek safety. This will also drive prices higher, and yields lower.
- Lower-quality bonds risky: Junk bonds are a bad bet when there is deflation. Deflation makes each interest payment increasingly expensive for companies. That’s because while the buying power of every dollar increases, interest payments remain the same. Imagine paying for a S$100,000 car by making S$5,000 monthly principal payments, with each payment 5 percent of the car’s original value. A year later, because of deflation, new cars now cost only S$80,000. Although your S$5,000 payments haven’t changed, they are now 6.25 percent of the truck’s value. In buying-power terms, your interest rate has, in effect, increased 25 percent. Apply that to companies that issue junk bonds, and you can see why the risk of defaulting on their payments would increase.
- Commodities mostly weak: Commodities and commodity-based companies usually are bad investments as economies slow and demand for commodities falls. But, gold prices often increase during global financial crises. As we’ve written before, gold is negatively correlated with many stock markets. In a world of deflation, the price of gold may rise as investors seek a safe haven.
- Be choosey with stocks: Deflation will maintain downward pressure on interest rates, and that’s good for companies’ borrowing costs. But, companies also will have a hard time increasing earnings if prices are falling and consumers and businesses cut back on spending. Emerging markets, heavily exposed to commodities, would be hurt.
Deflation isn’t here yet. But it may become an issue soon. And it could be a big problem, if it hits.