Friday, November 21, 2008

Inflation or Deflation - What's Next?

A good estimate of the rate of inflation allows a more accurate projection of funds and investment returns needed in retirement. For our retirement plan analysis, we have been using a 2.5% inflation estimate. Inflation data from 1997 to 2008 show that this is a reasonable value. During my lifetime, inflation has been typical. However, deflation has become a possibility in 2008.

The financial crisis of 2008 has contributed significantly to the deflation risk, causing severe credit tightening, a reduction in asset values and lower demand for goods. In October, 2008, the Consumer Price Index (CPI) fell 1%, the biggest drop since 1938. While lower prices seem beneficial, long term deflation causes a number of economic issues, including business failures due to lower profits, further declines in house prices, increasing burden for debt repayment, and delayed consumer spending. For reference, the Japanese economy stagnated as it experienced deflation for over a decade, beginning in the early 1990s.

Currently, the TIPS (Treasury Inflation-Protected Securities) bonds indicate an expectation of deflation. While it make take several months to reoccur, I think inflation is the more likely scenario. I believe that the combination of massive, increased government spending (TARP and other bailouts) and very low interest rates will cause inflation to occur, once lending returns to normal levels. For reference, the monetary growth created by the Fed is over 100% for the past three months, versus a normal 3-5% level.

Thus, for now, I don't have expect to make any major changes to our retirement plans. I will consider buying some TIPS bonds, which are significantly undervalued if inflation returns to 2-3%.

For more on Reaping the Rewards, check back every Friday for a new segment.

This is not financial advice. Please consult a professional advisor.

Copyright © 2008 Achievement Catalyst, LLC

3 comments:

golbguru said...

Super: quick question on this; how exactly do I go about buying bonds? May be you can write a post and I will link to it. :)

For example, to buy stocks/ETFs I just log in to my Zecco or Sharebuilder accounts and click a few options and *pooF* I get those shares in my account. Is the process similar for buying bonds? if not, what's different?

Any pitfalls I should look for before I get into this?
Any advice will be greatly appreciated.

Thanks.

Shadox said...

Recent economic policy is extremely inflationary and I do expect that we will get inflation which is potentially higher than the 2.5 - 35 range you are talking about. This is especially true if the Dollar is significantly devalued against our major trading partners' currencies.

Super Saver said...

@ Golbguru,

I usually buy bonds and CDs through the discount brokers I use, e.g., Schwab and Ameritrade. The process is similar to buying stocks, when buying a market. I found out TIPS couldn't be traded online and required broker involvement. However, there is no additional cost for having a broker involved in doing the trade.

I looked at Zecco's and Sharebuilder's website and didn't find a section on bonds. So they may not offer the service of buying and selling bonds on-line.