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20 questions, No. 5: Inflation, deflation: What's next?

Updated: May 3, 2013 12:14PM



What is inflation? What is deflation? We're hearing more about inflation and deflation these days. It's as if the economy were balanced on a seesaw, tilting one way and then another. But what are the true definitions - and consequences - of these terms?

Deflation: We think of deflation as "falling prices." That was the headline in Wednesday's announcement that the Consumer Price Index registered its first annual decline in more than 50 years. The index is now down 0.4 percent since March 2008, the first yearly drop since 1955.

Earlier in the week, the Producer Price Index showed prices at the wholesale level falling at the fastest rate since 1950. The monthly decline of 1.2 percent in the March PPI brought the annual rate of decline to 3.5 percent.

Leading the decline were falling gasoline prices, now down 50 percent year over year. In March 2008, gasoline prices averaged about $3.24 a gallon. This March, the average price was $1.96 per gallon.

Although you might not see it in your grocery cart, food prices also fell.

Falling prices are not necessarily a bad thing. If prices are dropping because of product improvements, such as we saw in technology for many years, that is a good sign for the economy. In that case, consumers get more value for their money.

But when prices fall because of excess capacity and lack of demand, then you have a deflationary problem that leads to economic slowdown and rising unemployment.

The deflationary downward spiral is devastating. Unemployed people simply do not have the money to buy things. They have also run out of credit as banks and other credit grantors cut back on lending, worried that existing loans won't be repaid.

In a period of deflation, the value of almost all assets and services declines. If you have cash during a deflation, you can get a bargain - whether on a house or on the services of an out-of-work carpenter or electrician.

But there is a psychological aspect of deflation that is more difficult to change. People who do have credit or cash may hold off buying stuff - even bargains - because they believe that prices will fall further. It becomes a cycle that's hard to break. That's exactly what happened in Japan, and caused a decade of stagnant economy.

Inflation: We tend to think of inflation as rising prices, which is how inflation is measured. But rising prices are just a symptom of inflation.

The real definition of inflation is a debasement of the currency. That is, a belief that paper money or credit is being created in such excess supply that you are better off getting rid of paper money and owning "things" of value - anything from gold coins to real estate to stocks to commodities. The rush to buy these "real assets" pushes prices higher.

That's one of the great dangers of inflation: The money you saved for the future (perhaps retirement) has less buying power when more money is being created. During a period of inflation, those living on fixed incomes find their dollars won't cover their rising cost of living expenses.

Inflation also brings higher interest rates. After all, no one wants to lend money for a number of years if they fear that when the loan is repaid, the money will have less buying power. So they demand higher interest rates to compensate for the expected decline in purchasing power.

Savers may take comfort in those higher interest rates, but if past experience (in the late 1970s) is any guide, those high interest rates only reflect a higher rate of destruction in their buying power. Even with higher rates on deposits, you're not really getting ahead.

The future: inflation or deflation?

Right now, everyone is watching these price measurements very carefully. There's little doubt that asset prices are falling around the world these days. But there's also plenty of evidence that new "money" and credit is being created by central banks, in their attempts to stave off a global depression.

At some point, all that excess credit is likely to trigger another round of inflation - fear for the future value of money. If you knew exactly when that balance would tip into inflation, you could make a fortune!

And that's the Savage Truth.



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