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Inflation? Deflation? It’s All About ‘Meflation’

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Pick your poison, says Wall Street. Either Uncle Sam’s borrowing binge will flood the system with money, leading to a replay of the 1970s as inflation eats away at your purchasing power. Or all that debt and the liquidation of distressed financial assets will paralyze the economy and send prices falling, like the deflation Japan has suffered for the past 20 years.

Market pundits everywhere are insisting that getting this “call” right is critical to investing success. The reason is obvious: If you design a portfolio meant to be a bulwark against inflation, and deflation stalks the land instead, your wealth will suffer. Likewise, a deflation-proof portfolio will get killed if inflation takes off.

No wonder online forums (and my mailbox) are full of questions from investors desperate to figure out whether they should protect against inflation or against deflation.

As obvious as it may sound, the belief that you ought to make a call and then overhaul your portfolio accordingly is wrong.

The problem is simple. No one knows how to predict, with any degree of reliability, whether the cost of living is going to go up or down. In 1979, as U.S. inflation was peaking, most experts predicted that it would stay high for years to come. Ten years later in Japan, the consensus was that stocks and real estate would continue to boom; no one foresaw that the nation was about to sink into a two-decade morass.

“What matters isn’t whether somebody’s forecast for inflation or deflation is more convincing to you,” says Larry Swedroe, director of research at Buckingham Asset Management in St. Louis. “Instead, what matters is which of these risks would be most damaging to you.”

So stop trying to guess the answer to the highly uncertain question of whether we will be hit with inflation or deflation. Start thinking about the much more knowable issue of what I call “meflation”: the direct, personal impact of the changing cost of living on your investments, your budget and your labor income.

Depending on your circumstances, either a rise or a fall in the cost of living could be good for you.

If you are a bright 30-year-old with a good job, a stock-heavy portfolio and a fixed-rate mortgage on your house, moderate inflation is probably a good outcome, Mr. Swedroe says. Your wages should rise roughly in tandem with the cost of living, you can pay off your mortgage with cheaper dollars over time, and the value of your stocks and your home should eventually go up.
An Imminent Threat

Your more imminent threat is deflation, which may jeopardize your job security, can hurt the value of your stocks and will raise the real value of paying off your mortgage, even as it depresses how much your home is worth.

But if you are a retiree living on Social Security and pension income, the last thing you should worry about is deflation. Falling prices would be good for you. With each passing month of falling prices, your income would go further. (The government adjusts Social Security payments up to compensate for inflation, but doesn’t cut them when prices fall.)

Thus what you should worry about is a rise in the cost of living—since your income is fixed and your potential earnings as an employee, if you did try to return to the work force, are fairly limited.

If deflation is the bigger danger for you, consider Japan. Its stock market peaked at year-end 1989. If you had then been gifted with perfect foresight, what should you have done? Since then, stocks have lost an annual average of 6%, net of changes in the cost of living, according to data from Elroy Dimson, Paul Marsh and Mike Staunton of London Business School. Long-term bonds, meanwhile, gained 5.3% annually—and would likely do well here, too, if deflation lingers. Only at low levels of deflation would stocks do moderately well.
TIPS, REITs, Commodities

If inflation looms as the larger threat, it isn’t clear that commodities—the hedge du jour—will offer you much protection in the long run. As the great investor Benjamin Graham warned in 1974: “It is impossible for any really large sums of money … to be invested in such tangibles … without creating a huge advance in the price level, thus creating a typical speculative cycle ending in the inevitable crash.”

Your best bet remains Treasury inflation-protected securities, or TIPS, whose principal value goes up as the cost of living rises. Real-estate investment trusts, or REITs, offer a modicum of protection against inflation, as do stocks in general.

So forget the experts—you are the only one who can forecast which -flation you should fear.


Written by Theophyle

September 11, 2010 at 9:56 am

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  1. […] Inflation? Deflation? It's All About 'Meflation' « Politeía Digest […]

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    September 14, 2010 at 3:03 pm

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