NEW YORK (TheStreet ) -- With low inflation in the U.S. and Europe flirting with deflation, the Federal Reserve is focused on making sure the U.S. doesn't fall into a deflationary spiral.
What does that mean and how might it affect your investments?
The Federal Reserve has several objectives for the economy that it seeks to achieve, one of the more important ones being its target for inflation. Largely derived from the CPI. PPI. and PCE indices, the Fed has a goal of 2% inflation. Right now, U.S. inflation is at 0.0%.
Inflation means the buying power of your dollars is eroding. Why is this an objective for almost all central banks? Because inflation's antithesis, deflation, is a far more deleterious force for markets. Europe in particular has been struggling to avoid it and has even begun its own quantitative easing stimulus to help combat deflationary fears and anemic growth.
During deflation, your dollars increase in worth and prices fall, so why is this so insidious for economies that are subjected to it? Well, if deflation occurred in a vacuum perhaps it wouldn't be so harmful, however there are numerous externalities that exert pernicious
effects on markets as a result. Understanding why this is so is quite helpful for investors and may make for better asset allocation if we ever experience it.
Deflation's Negative Effects
1. Prices fall and the value of the dollar increases as a result of deflation. Viscerally these may appear as good things, however it's highly counterproductive for spending, which is the very action that buttresses economies -- especially the U.S. economy. Holding cash actually becomes an investment with a real yield. Coalesce this with the prices of goods and services falling, and it becomes prudent to put off purchases as you'll be able to procure them for less if you wait.
2. It stymies credit markets. The burden on debtors is compounded during deflationary periods as they now not only must pay interest on their loans, they must do so with dollars that will become more expensive to come by. This makes for a material increase in one's propensity for defaulting. It also makes borrowers far less likely to seek out loans, even for productive economic purposes. This elevated burden on debtors in addition to dissuading borrowing curtails investment-led activity and constrains growth.