Goldilocks and the Bear Market – Why Is Deflation Not A Fairy Tale?

This article was originally published on Quadrant Group’s website. Quadrant Group was acquired by Progeny in March 2017.

Since the early nineties, inflation targeting has been a tool for the UK’s central bank interest rate policy. It’s a simple principle based on the ‘Goldilocks’ rate of 2%. Economists have determined that this is the perfect rate, not too high or too low, but just right to sustain moderate economic growth and low inflation, which allows a market-friendly monetary policy. With this guidance, the Bank of England looks at its inflation forecast: if it is above the target it will raise interest rates to slow spending and curb the price of goods; if it is below the target then interest rates are cut to promote spending and stimulate the economy.

In a speech given by Mervyn King at the London School of Economics in 2012 to mark the anniversary of inflation targeting, he said: “During the past twenty years, annual consumer price inflation in this country has averaged 2.1%, remarkably close to the 2% target and well below the averages of over 12% a year in the 1970s and nearly 6% a year in the 1980s.”

But the story doesn’t end there. In recent weeks, inflation has fallen to an all-time low of 0.3% and is expected to continue below zero. The British economy is likely to experience a negative inflation rate, also called deflation, for the first time since records began in 1989. The most ominous example of deflation is the Great Depression. Much has been written about the catastrophic interest rate rises which many historians blame for the prolonged recovery. However not all episodes of deflation correspond with periods of poor economic growth.

Bank of England Governor, Mark Carney has allayed making comparisons between the current deflation scenario in Britain to the 1930s. In a speech last week given at Sheffield University he made it clear that: “The Bank expects to return inflation to target within two years and to make limited and gradual increases in Bank Rate over the next three years in order to achieve that in a sustainable manner.”

Why is Inflation So Low?

Inflation decreases when either the supply of money is scarcer, and consequently the purchasing power of each unit of currency increases, or when improvements in production efficiency lower the overall price of goods. Competition in the marketplace often prompts those producers to apply at least some portion of these cost savings into reducing the asking price for their goods. When this happens, consumers pay less for those goods, and consequently deflation has occurred, since purchasing power has increased.

As of late, we have been cheering when we fill up at the petrol pump because the price of oil has sharply declined. The ‘bear market’ in crude oil has largely been driven by a glut in supply creating a knock on effect reducing the cost of food and energy. It seems that much of the shortfall between actual inflation and the target 2% is the result of ‘good deflation’.  This should boost the economy as long as wages continue to grow. Deflation, if it is only for a short period, will give families the biggest boost to their finances for more than a decade which Carney has hailed as “unambiguously good” for economic growth.

Should Deflation Be Avoided?

Deflation is generally regarded negatively, as it causes a transfer of wealth from borrowers and holders of illiquid assets to the benefit of savers and of holders of liquid assets and currency. In this sense it is the opposite of the more usual scenario of inflation, whose effect is to tax currency holders and lenders (savers) and use the proceeds to subsidize borrowers, including governments.

While an increase in purchasing power benefits some, it amplifies the sting of debt for others: after a period of deflation, the payments to service a debt represent a larger amount of purchasing power than they did when the debt was first incurred. Consequently, deflation can be thought of as an effective increase in a loan’s interest rate.

Carney voiced a note of caution about the danger of inflation remaining low. “As you know, when a household takes out a mortgage or a firm takes out a loan, the amount owed is denominated in cash terms – in other words, not adjusted for inflation. And so if there’s unexpected or generalised falls in prices that means the real value of that debt increases: the same amount of money is owed, but that money now buys more goods and services. And as a result, more consumption and investment needs to be foregone in order to service that debt. And it’s that negative feedback loop, that vortex, that debt-deflation dynamic that was at the core of the Great Depression and at the core of the Japanese malaise following the collapse of the asset bubbles there in the 1980s.”

How Do We Return to the Goldilocks Rate?

The most important factor to experiencing a short period of ‘good deflation’ is the continued rise of wages. Consumer spending is also crucial. If wages fall or households put off purchases because they think it may be cheaper later, inflation will continue downward. However, the latter at least seems unlikely. Items such as food and fuel cannot be delayed and generally the desire for instant gratification means that people are unwilling to wait for cheaper prices still. We have a very different mind-set for consumerism than previous generations.

Interest rates are doubtful to be cut beyond their current 0.5%, so the only way is up. However, it is unlikely that the bank rate will be increased until further signs of stability are seen. Carney has indicated that a rate rise is certainly desired but may not occur until 2016.

The European Central Bank announced on Monday a 60 billion euro per month public-sector bond purchase until September 2016, which will pump more than 1 trillion into the eurozone economy. In the UK, there may be more quantitative easing or large scale asset purchases if the economy fails to pick-up.

What Does This Mean for Investors?

Deflation retards investment even when there is a real-world demand not being met. In modern economies, negative inflation is usually caused by a drop in aggregate demand, and is associated with economic depression.

Where the risk-adjusted return on assets drops to negative, investors and buyers will hoard currency rather than invest it, even in the most solid of securities. However, if what we are experiencing is temporary low inflation it will mean higher consumer spending – and that is positive for markets. There is little advice from fund managers except to hold – now is not the time for any sudden moves.

As part of our comprehensive Wealth Partnership planning process, we make sure that a mix of assets that behave differently are combined at all portfolio levels, because we can never be sure of what the market will do at any moment. Diversifying your portfolio is by far the best way to ensure the most positive outcome for your investment over the long term. By diversifying, you can expect to live happily ever after.

Read more about Quadrant Group’s investment approach, and get in touch with us to learn more about how you can diversify your portfolio.

This article does not constitute financial advice. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial planner to take into account your particular investment objectives, financial situation and individual needs. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections.

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and the value of investments can fall as well as rise. No representation is made that the stated results will be replicated.

Andrew Pereira

Director, Wealth

Andrew has been working with families, high-net-worth clients and business owners for well over 20 years.

Learn more about Andrew Pereira