Question: Could you address the concept of deflation?

J. Glasse

Answer:

Dear J. Glasse,

Let’s first explain deflation for those who are unfamiliar with the concept.

A definition...

Deflation is a general decline in prices for a prolonged period of time. How much of a decline and for how long has never been specified by economists. However, you can assume it’s not temporary or passing and that it lasts for at least one quarter or three months. Simply put, it is the opposite of inflation, which we’re all too familiar with.

Deflation is usually caused by a reduction in the supply of money or, the closely related scenario -- by a reduction in available credit.

This prolonged slide in prices can lead to increased unemployment because there is less demand for products and services. And when incomes are reduced this usually means a rise in loan defaults.

The current scene... 

We learned this week that the cost of living fell by 1% last month. Much of the drop was in the area of energy, followed by food. During that same month, construction of new homes was also at a low. These two statistics sent a message that we may encounter deflation.

However, we’re not there yet. Nevertheless, if the decline in prices spreads significantly beyond energy and food, it could lead to a true deflationary period and thus make it difficult for our economy to recover.

What might happen... 

In order to prevent deflation, it’s possible that the Federal Reserve Board will cut interest rates at its next meeting, scheduled for December 16th. They would do so in an effort to make it easier for consumers (and businesses) to pay off their debts which would also be a shot in the arm to troubled banks.

Some positives...

There are some benefits to a pre-deflationary period, provided it doesn’t become more serious. You’ll find that retailers may cut prices on certain items to attract customers, making it a good time to buy certain items, but only provided you don’t go into debt to do so. In fact, several retailers recently announced that they are reducing prices on Thanksgiving food items and holiday merchandise.

You may have noticed that prices have also come down on new cars and clothing as car dealers and retailers seek ways to pull buyers onto car lots and into malls.

If you have money available, this is also an ideal time to take a cruise, a tour to Europe, Asia or South America or check into a hotel for a weekend getaway – these three segments of the travel industry have reduced current prices. In the case of cruises and packaged tours, prices also have been cut for the early part of 2009. (This is not true for hotels, however as they have greater ability to adjust prices within a smaller time frame.) And, some airlines have dropped fares temporarily on some flights.

Your favorite stocks may also be reasonably priced right now creating an opportunity to increase your positions.

And, as we’ve mentioned in previous columns, this is a buyer’s market when it comes to most real estate.