Why deflation changes the rules

By David McEwen

Monday 11th March 2002

The low inflation environment we have enjoyed for a decade or more has been a boon for investors.

Inflation reduces the value of money over time, making life difficult for those on fixed incomes or with assets which yield a return that doesn't keep up with inflation. Inflation of two per cent is easier to outperform than when it is running at 20 per cent.

Nobody wants to see a return to the bad old days of rampant inflation but the danger for the world economy is actually its reverse, deflation.

Plunging prices and asset values in Japan, the world's second largest economy, mean that country is already experiencing deflation and there is a danger it could catch on in other economies.

If it does, and should ever reach our shores, investors need to be prepared.

When deflation takes hold in an economy, which is has not done in the western world since the 1930s depression, then the rules change.

Money becomes worth more over time as prices fall. While this may sound like a wonderful thing (put the price of a loaf of bread under the mattress and wait until it can buy you a Rolls Royce) its effects can be worse than inflation.

Money may up in value but so does debt. This can have a crippling effect on people, companies and countries with high levels of debt (such as New Zealand).

When people know their money is going to be worth more tomorrow, they put off buying anything today. They also tend to pay off debt first.

Less spending means businesses earn less. They respond by cutting costs, delaying investment and laying off staff. Unemployed people have less to spend while those in fear of their jobs start hoarding cash. This can lead to a highly damaging deflationary spiral.

During tough times, governments and central banks try to stimulate the economy by lowering interest rates. This is very effective when there is inflation but doesn't work in a deflationary environment. Interest rates can only go to zero.

This can lead to the seemingly bizarre situation, which already exists in Japan, where people are happy to have their money in the bank earning zero per cent. This is because deflation in that country has been running at around 4%, which means money is going up in value by the same rate each year. Therefore, savers are getting the equivalent of 8 per cent interest under normal circumstances, or four percent after tax and inflation at,
say, two per cent. As a result, there is no incentive to spend or invest, which makes deflation very hard to escape.

While such an outcome is not likely in New Zealand, it cannot be ruled out.

The Reserve Bank has the job of keeping inflation at between zero per cent and three per cent, which is small enough to be virtuous. If that rate should fall below zero and stay there, the bank has little ammunition to fight it.

In a deflationary environment, investors should favour fixed interest investments such as long-term government stock or listed companies with minimal debt, good cash flows and secure markets.

Secure markets represent goods and services that people need and therefore cannot delay purchasing. These are generally the basics of life like energy, food and healthcare services.

David McEwen is an investment adviser and author of weekly share market newsletter McEwen's Investment Report. He is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. He can be reached by email at davidm@mcewen.co.nz.

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