Monday, 27 January 2014

The ogre of deflation – should we be scared?

Christine Lagarde, the Managing Director of the IMF said earlier this week that the ogre of deflation has not yet been slain.  By deflation, of course, she meant a general decline in prices.  Falling prices may not sound too bad – instinctively it sounds quite good, so why does deflation take the form of an ogre which haunts the nightmares of Christine Lagarde?

In simplistic terms, companies make lump sum investments and then receive a growing stream of income from those investments. If the stream of income is shrinking, because prices are falling, that makes the investment less attractive. That's not a good environment for investing in company shares.

So do we prefer inflation?  Not really. The truth is that too much of anything can be bad for you.  Too much inflation and interest rates and investors will find attractive returns away from the equity market.  Too much deflation and equity returns will be poor as company profits will stop rising.

What does that mean for me?
Falling inflation is positive for investors because monetary policy can remain loose – by that we mean interest rates will stay low making equities and bonds attractive.  Ultimately, high interest rates tend to be poison for a bull equity market – usually within a year or so. Low inflation makes higher interest rates an unlikely proposition.

For savers, low inflation is better news but, even with the recent fall, a savings pot earning the Bank of England base rate would be able to by less goods every year due to the effects of inflation.  Outright deflation would change that, but there is little evidence that the current fall in prices represents the start of a general price fall in the UK.  Rather it seems to be the rolling off of the tax hikes implemented as part of the austerity drive of recent years as show by the graph below which shows the normal rate of consumer price changes and what they would have been had taxes been kept constant.

The ogres of deflation and inflation appear equally tame for now.

Guy Foster
Head of Portfolio Strategy

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