When the European Central Bank slashed its overnight rate last week it admitted the truth about its record monetary interventions over the past 3 years: they have not succeeded in their stated goal of creating inflation. Weak global demand, record unemployment and massive over-capacity have all managed to outweigh the feverish attempts by central bankers to reflate the global economy. Even after trillions of liquidity injections dumped into the financial system, the world is growing today at about half the rate clocked at the credit bubble peak in 2007.
Conditioned on the inflationary experiences of the 1980’s and 1990’s, few people or experts today comprehend what an era of deflation portends. Unlike inflation that erodes purchasing power over time, deflation reduces relative prices (and corporate revenues and earnings) and thereby increases the purchasing power of cash. In a deflationary environment, investment returns are driven by increased purchasing power after prices drop, much more than through income yields while one waits. Inflation increases wages and prices and therefore decreases the weight of fixed debt repayments. Deflation on the other hand, penalizes those in debt and holding inflated assets and rewards those with low debt, cash and high quality bonds.
In other words, deflation rewards those who have been prudent fiscal managers, and penalizes those who have not. This is why deflation scares the hell out of investment bankers and those who are levered off an assumption of rising stock, commodities and real estate prices over the next couple of years. But it brings great opportunities for those who have been managing their risk, controlling their costs, and building their liquid savings.
For a rare and excellent summary of the investment implications of the present deflationary environment, see: Deflation threat in Europe may prompt investment rethink