What is Inflation, Deflation, Stagflation?

In economics, experts love to use complex terms to explain simple subjects. Well, for today’s post, we’re going to break down what is inflation, deflation and stagflation in simple terms including what that means for you and me – the passionate DIY investor.

Read on and let us know your thoughts!

What is Inflation, Deflation, Stagflation?

What is Inflation?

At the most basic level, inflation means a rise in the general level of prices of goods and/or services over a period of time. When inflation occurs, each unit of currency buys fewer goods and services. Inflation results in a loss in the value of money and purchasing power.

For example, if the inflation rate is 2%, then a loaf of bread today that costs $1 will cost $1.02 the next year. In future years, that loaf of bread may cost $1.05 or even $1.20 in a few years, and so on.

When it comes to inflation, we’re seeing this play out in real-time right now. More on that in a bit.

What is CPI?

StatsCan (Statistics Canada) does a fine job reporting on inflation and the changes in prices we experience as Canadian consumers. They use a metric called the Consumer Price Index (CPI) that measures price changes by comparing, through time, the cost of a fixed basket of goods and services.

The goods and services in the CPI basket are divided into some major elements:

Food
Shelter
Household operations
Furnishings and equipment
Clothing and footwear
Transportation
Health and personal care
Recreation
Education and reading
Alcoholic beverages, tobacco products and recreational cannabis.

That CPI data is published at various levels of geography across the ten provinces, and include Whitehorse, Yellowknife and Iqaluit, and select cities.

You can find more details on CPI at any time here.

In recent months, inflation has spiked and year over year CPI tells an important tale for investors paying attention.

Prices rose year over year in every major component this fall, in September, with transportation prices (+9.1%) contributing the most to the all-items increase. Higher shelter (+4.8%) and food prices (+3.9%) also contributed to the growth in the all-items CPI for September.

“Prices at the gas pump rose 32.8% compared with September last year. The contributors to the year-over-year gain include lower price levels in 2020 and reduced crude output by major oil-producing countries compared with pre-pandemic levels.”
Source: StatsCan

Food prices were up. Home prices were up. Essentially most goods and services were up. And unlike the stock market for a soon-to-be aspiring retiree, whereby things are “up” are a good thing, inflation ramping up is not generally a good thing for many of us.

Why is Inflation Bad?

Inflation is very much a double-edged sword. Higher prices that consumers pay for goods and services may completely gobble up their extra savings. While savings rates on savings accounts will essentially move higher, instead of practically paying no yield, the loss of purchasing power with higher inflation happens fast – eroding purchasing power. This is of course contrary to the low-inflation, low-interest-rate environment (like the pre-pandemic dynamic) we’ve experienced – somewhat optimal for consumers and producers and also from a tax perspective.

Yet going forward, we’ll go on record at Cashflows & Portfolios to say this inflation-thing is not “transitory” as some experts believe. That “transitory” buzzword came out months ago. We believe some higher levels of inflation are here to stay. So prepare for it in 2022 and 2023. You heard it here!

That means if you own assets, inflation can be generally a good thing. If people owe you money, lots of it, inflation is not so good.

Think of it this way: a bond is essentially an IOU with some interest. Someone holding a low-interest bond with any decent time horizon may be stuck with a paltry return or you might lose out to inflation. On the flip side, if you are a homeowner with a real estate asset, with a low-mortgage rate who better still might have locked in their fixed mortgage at a low-interest rate, then you’re going to be in decent shape. Your home value/real estate is likely to inflate (with inflation) but your monthly debt obligations will remain the same.

When it comes to stocks and stock sectors, stocks may not be a direct inflation winner, but they have historically outrun inflation over the long term. Here are some sectors that are correlated (or not) to inflation:

Source: MarketWatch

As the chart above shows, the S&P 500 overall has a positive correlation with the differential of 0.18 with inflation. Some sectors are, however, negatively correlated.

(Correlation measures the strength of a relationship between two variables. A positive correlation of 1.0 would mean they move in the same direction in lockstep, while a correlation of -1.0 would mean they move equally in opposite directions. A correlation of 0 means there is no statistical relationship.)

Something to think about right – more stocks in some sectors perhaps?

Further Reading: What is inflation and what are the best investments to fight inflation?

What is Deflation?

Think of a bicycle tire – it can deflate – including over longer periods of time.

Deflation is therefore the opposite of inflation – allowing one to buy more goods with the same amount of money over time.

Deflation can occur when there is a reduction in the supply of money or credit. In most cases, deflation occurs due to contractions in spending; personal, business or the government as well. With less money in supply or tightening of credit, deflation often results in increasing unemployment and overall no-growth or periods of negative growth.

Why is Deflation Bad?

Economists generally fear deflation because falling prices are not a sign of growth. Companies respond to falling prices by lowering their production and output targets. Lower production can therefore trigger layoffs and spike unemployment. A recent case study in Switzerland.

Back in the summer of 2020, the Swiss National Bank (SNB) said it would maintain its negative rate of interest (-0.75%) for a short period of time.

Source: ING

Is there a way to invest when it comes to deflation – should it happen?

Not really but we have a few ideas in no particular order:

Keep some cash. Down markets could be a buying opportunity for equities or some sectors. Historically, metals (see gold) can offer a “safe haven” but nothing is really deflation-proof since producers might need to cut back as well.
Think recession-proof sectors. While healthcare companies, utilities, consumer-based companies, and grocers are not immune to deflation, yet such sectors and companies in those sectors are probably going to be just fine. Everyone needs healthcare, everyone likes electricity, and people need to eat. We love dividend-paying stocks in these sectors and own many ourselves. Further Reading: Is Dividend Investing Right for You?
Minimize debt. Enough said!

Over centuries, the developed markets (U.S. and Canada) in particular have experienced more periods of inflation than deflation. The last big period of deflation occurred during The Great Depression and a more recent example almost 15 years ago was the Great Financial Crisis – that impacted our personal portfolios as well. During times of recession and deflation, as we have expressed above, people can lose their jobs and therefore the demand for supplies and goods drops too – people don’t generally spend money at those times.

If you want a prolonged case study in a sluggish growth environment (understatement), read this: Japan’s Lost Decade – Lessons for Other Economies.

Before we leave this theme – it would be hard to overstate the degree to which psychology drives an economy’s shift to deflation. As creditors become more conservative and feel the need to behave accordingly, they slow their lending. As potential debtors become more conservative, they borrow less or not at all. As investors become more conservative, they commit less money to debt investments or leverage. As producers, businesses become more conservative and slow projects. And finally, as consumers, we simply save more and spend less.

Deflation is very problematic in our opinion because we don’t believe any central bank can control it. In reading that Japan document above, the Japanese government spent decades injecting money into their system – but that didn’t do a darn thing. There was no magic turnaround. Injecting money was not a silver bullet. Worse still, if you’ve been borrowing your brains out (like the governments in the U.S. and Canada have lately), government debts may only compound the problem in time…

So, when it comes to surviving any potential deflationary period, and it could happen (!), we believe cash and cash flow are kings. While cash and ongoing cash flow to you is not the only solution, keep in mind as stocks, bonds, real estate, and various commodities lose value, the amount of cash required to purchase these assets is falling – so we believe cash on hand to purchase assets at depreciated prices is relatively valuable.

What is Stagflation?

Stagflation is essentially a combination of stagnant economic growth, high unemployment, and high inflation.

Yikes!

Stagflation occurs when the government or central banks expand the money supply (i.e., print money) and inflation occurs at the same time.

Is this occurring now?

You could make a slight case for that…..and we’ve seen this before….but it might not happen again.

Why is Stagflation Bad?

It has been written the economies and societies of the developed world were convulsed by a perfect in the 1970s: high unemployment and rocketing prices throughout much of the decade.

It is my hope we have learned lessons from the past: stagflation got its name during the early 70s recession, when GDP growth was negative for many consecutive quarters, triggered by bad and conflicting fiscal policies. It is unlikely to occur today for that reason, but you never know! Governments tend to have a short-term memory!

Summary – What is Inflation, Deflation, Stagflation?

We cannot know what the future holds with any sort of accuracy, so don’t let any experts convince you otherwise. At Cashflows & Portfolios, we can say that the following keys may be helpful in an era of modest inflation, deflation or stagflation.

Keep some cash – cash is always handy, it’s liquid and versatile.
Avoid too much leverage – large amounts of debt can be crippling when you least expect it.
Keep a bias to equities in your portfolio – cash and bonds, can be losers to inflation and tend to trail equity returns over time.

We hope this post was the primer you need to navigate the messy world of macroeconomics!

At Cashflows & Portfolios, even though our investment plans are very similar many of our holdings are actually very different – personal finance has been and will always be – personal. We hold different quantities of cash, stocks and other assets between us. Your mileage will likely vary too.

Personal retirement income projections can be found – right here!

Whether it’s inflation, deflation, stagflation or other economic cycles – we believe knowing how to get the most out of your portfolio, is something you should know and something we can help with.

If you need help solving your retirement decumulation puzzle (i.e., how to efficiently withdraw from your retirement accounts), or figuring out if you have enough saved to spend for your retirement income plans, we’re here to help answer those questions and more as well!

If you are interested in obtaining private projections for your financial scenario, read more about our retirement projections service.

We’ve already helped out dozens of clients in just a few short months and we can help you too!

Have a read of our popular Retirement Projections page to learn more, ask us any questions about our process and services, what value we’ve already provided other clients, and what we can do for you!

Thanks for your readership and see you in our comments section.

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