Deflation October 27, 1997February 3, 2017 Two questions on deflation. The first, in appropriately deflated lower case: w. buffett, j. templeton, and other well-respected investors are rumored to be buying us bonds. is the possibility of deflation, similar to the asian situation, the reason? do you think such a deflation is likely? if so, what might trigger it? are you buying bonds? thanks jbrimi The second, from Professor Dana Dlott: Have you ever given any thought to deflation? My concern stems from several events. First, a few years ago I bought a house a bit more expensive than I can afford. I reasoned, as do millions, with a little bit of inflation, I am in great shape. About that time I read a biography of William Jennings Bryan. You may remember from history about the famous “Cross of Gold” speech and the “free-silver” movement. It was never explained to me very well in US History. This was during a period of deflation, which was common in the 18th and 19th centuries. The probable reason for deflation was the economy was expanding rapidly but the money supply, based on gold, was not. The ravages of deflation were terrible. If you owned a farm and had a mortgage, pretty soon the value of the farm dropped below your mortgage debt, which triggered the banks to foreclose. You were just working hard, farming and making money, and BAM there went the farm. It didn’t help the banks any, either, to have all this bad debt and farm land. The “free-silver” movement was about using silver for coinage, to expand the money supply to counter this deflation. The “Cross of Gold” speech was about how the Wall Streeters and Washingtonians were crucifying the average person by keeping to the gold standard. I wasn’t really worried about deflation because I reasoned the government could just print more money. But recent events have me worried again. First I heard an interview with one of the Federal Reserve Governors. He said to the Federal Reserve Board, the desired rate of inflation was zero. That was a bit of a shock. I was taught a little bit of inflation was good because people like getting annual raises and the money supply should expand a bit. If the targeted inflation rate is actually ZERO, then errors in this targeting could easily lead to deflation. In addition, now I am reading the Producer Price Index has fallen for the 7th straight month. [This e-mail came in late August.] Any comments or insights? Am I crazy to worry about deflation? Nobody else seems to worry about it, or even mention it. It would be disastrous for a lot of people in debt. Well, my first comment and insight on deflation is that, yep, it would be disastrous for a lot of people in debt. My second thought is that you can’t push effectively on a string, which is why lowering interest rates or printing more money can’t necessarily be counted on to stave off deflation. Interest rates in Japan have long been close to zero, but if people and businesses are scared to borrow, you can’t force them to. And printing more money doesn’t necessarily bid up prices because of what’s known as the “velocity of money.” The Fed can inflate the money supply by purchasing Treasury securities and “paying” for them with new out-of-thin-air dollars it’s printed. (These days, a lot of the “printing” would involve nothing more than electronic ledger entries.) But the behavior of individuals and consumers can counter that if they choose to sit on more of their money rather than spend it — to keep higher checking and savings account balances, and use new cash to pay down debt rather than bid up the prices of Cabbage Patch dolls. The velocity of money — the speed with which dollars fly around the system and the amount of transactional work each dollar does — slows down. That said, I think deflation is unlikely and that, yes, the Fed’s tools are potent indeed. The world’s learned a lot since, and from, the Depression, most particularly about the money supply and the importance of avoiding trade wars. (Trade wars are one thing that could trigger deflation. Gloom and doom — we are emotional animals, after all — are another. Picture a period of falling profits brought on by global overcapacity, layoffs, increasing competition for work leading to underbidding, people getting scared and selling at any price to pay off their debts and raise some cash, which leads to lower stock prices and more gloom and, as Franklin Delano Roosevelt said: “All we have to fear is fear itself.” So it certainly could happen. And it’s wise to have some of one’s money in a deflation hedge like Treasury bonds. But I, for one, being an optimist, don’t see this as likely.) The Fed must always talk about a sound dollar and shooting for zero inflation. This gives people confidence in the future and reason to make the kinds of long-term arrangements and investments that build the future. Because interest rates sit on top of inflation expectations, this kind of talk from the Fed keeps interest rates low. People forget: From 1880 to 1965, there was no such thing in this country as a home mortgage over 6%. Treasury bonds yielded from 1% to 3%. With the prime rate at 8.5% and long-term Treasuries yielding a bit above 6%, the Fed has tremendous room to stimulate the economy with lower rates if deflation fears became more widespread. In an ideal world, the Fed would have people a little worried about inflation and a little worried about deflation, but basically confident that the dollar will be sound, prices stable, and that the Fed will and can do whatever’s required to keep it that way. And, yes, I suspect the Fed would be secretly pleased with a wisp of inflation — a sort of hidden psychological/social lubricant that keeps people happy — so long as they were publicly perceived to be fighting it. So, finally, what about buying bonds? If Buffett and others are, it would be because it’s so much more attractive to earn 6% on your money for a year or two than, say, nothing — let alone to lose 25%. Now, you may say the U.S. stock market couldn’t possibly go down 25% (or 40% or 60%), and you may be right. I still own lots of stocks for which I have high hopes, too. But for the market to fall 25% from 8000 would bring the Dow back to 6000, a level so impossibly high it was barely dreamed of by most people two or three years ago. Clearly, though, Warren Buffett et al. are not selling all their stocks to go into bonds, and neither should most of you. (Nor need you buy 30-year bonds, which expose you to interest-rate risk. Unless you do want to make an aggressive bet on falling interest rates — in which case you should consider long-term zero-coupon bonds to get the most oomph from your bet — it’s probably wisest for most people to stick to Treasuries that are 3-5 years from maturity. You’ll get almost as high a return on your money with a lot less interest-rate risk.) The future is bright, even if most mutual fund holders are likely to be deeply disappointed over the next decade, given the sort of annual returns they’ve been telling pollsters they expect to earn. One last thing. Did you know that The Wizard of Oz was actually about William Jennings Bryan and the Cross of Gold (follow the yellow brick road) and such? I was astounded to learn this, but as I hope to elaborate for you one of these days — unlike, say, the Procter & Gamble Satan thing — it appears to be real.