Back to Zero: Deflation Fears Emerge (Sonders)

This article is a guest contribution by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key points

  • Deflation now, inflation later?
  • Double-dip fears are subsiding ā€¦ will that ease deflation fears?
  • Investors need to understand deflation risk's impact on markets.

Although the fears about inflation have unquestionably subsided, I'm still surprised how often I get questions about its perceived inevitability ā€¦ regardless of any actual evidence that it's here or near.

Deflation, a scarier prospect, frankly, than even hyper-inflation, has emerged as a key worry. It may help to explain the market's bouts with indigestion this year, as well as valuations that are not keeping pace with stellar earnings growth.

Fortunately, deflation is fairly rare, and is typically associated with a Depression-like plunge in demand of all stripes. Prices not only fall during deflationary periods but, typically, so do asset prices and incomes. In response, interest rates tend to fall to rock-bottom levels, which on the surface may seem like a good thing.

But here's the rub: Even though the Federal Reserve has typically lowered rates aggressively, the cost of servicing debt for many remains elevated given that the plunge in asset prices disallows refinancings. Does this all sound familiar?

(click play to listen)

Liz Ann talks about deflation fears
August 2, 2010

Inflation fears plummet

As you can see in the chart below, inflation expectations, as measured by the yield on five-year Treasury Inflation-Protected Securities (TIPS), have plummeted from the peak in late-2008 when inflation fears were full-blown thanks to the Fed's stimulus.

Low inflation expectations

Click to enlarge
Source: FactSet and Federal Reserve, as of July 29, 2010.

TIPS' yields are clearly not negative, but for some they're too close for comfort.

Why buy/invest now?

Deflation halts every variety of activity as consumers, business and investors go into postpone mode due to the expectation that prices/costs will be lower in the futureā€”that's why it's so toxic to economic growth. Add to that rates typically already at rock-bottom levels, and the Fed is left in a bind without its traditional policy lever to pull.

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