Deflation - Would It Really Be All That Bad?

Includes: IVV, SPY, VOO
by: The Financial Lexicon

After much consideration, I've decided to reveal to the world a weakness of mine: I love Triscuits. I love them so much that I've even largely forgone bread when making sandwiches at home, instead choosing to take the extra time of making several small sandwiches using lunchmeats and Triscuits. As you might imagine, it is much more economical to use bread rather than Triscuits on a sandwich, but I can't resist. Like I said, Triscuits are a weakness of mine.

A couple of days ago, I went to my local supermarket to pick up some items, and, while walking down the aisle in which cracker-like snacks are shelved, I stopped dead in my tracks. Normally, I make all my Triscuits purchases at my local Target (NYSE:TGT). In fact, I've also started to make a lot of other purchases at my local Target rather than at my local supermarket because Target offers the same products, in the same sizes, at much cheaper prices. Concerning Triscuits, an 8 oz. box at my local Target is regularly priced at $2.59. At my local supermarket, however, the regular price was $4.29, and the sale price rarely made it lower than Target's $2.59. As a result, I almost never purchase Triscuits from my local supermarket. But what I saw in the cracker aisle the other day may have changed things.

The supermarket where I shop just dropped the regular price of an 8 oz. box of Triscuits from $4.29 to $2.77. I immediately picked up a box thinking Mondelez International (NASDAQ:MDLZ) must have reduced the size of the box and that the price drop really wasn't a price drop but instead an example of stealth inflation. But it wasn't. The size of the box remained at 8 oz. In addition, not only was the regular price reduced, but my favorite cracker was on sale for $1.77 per box. "Surely, these must be boxes that expire in the next few weeks," I thought. But no, the expiration dates were all a relatively standard four months in the future. Unbelievably, the price had simply dropped to $1.77 (on sale) with no shenanigans of any type to report.

Over the years, I have lost track of the number of times I've heard that deflation is bad. The reason most often cited for deflation being bad is that if prices are expected to drop in the future, then present-day purchases will be delayed. While I know that I will not reduce my purchases due to an expectation of, say, 1% deflation each year, perhaps others will. Although I have a hard time believing that most Americans would forego a purchase because they believe they can purchase something 1% cheaper in a year. Even if I were making a very large purchase, given the prevalence of sales in today's society, 1% is pretty much a rounding error that likely wouldn't change things either way for most people. So from a consumer shopping point of view, I think deflation of, say, 1%, on the regular price of items would not reduce the quantity of items most people purchase in a given year. Moreover, the feelings of excitement and relief from seeing prices come down might actually increase sales for many businesses. Let me serve as one example.

Normally, when I buy Triscuits at my local Target, I purchase three to five boxes at a time. What did I do when I saw the 8 oz. box of Triscuits on sale at my local supermarket for $1.77? I bought nine. In fact, I also bought three boxes of Wheat Thins, which were also on sale for $1.77 per box. And I almost never buy Wheat Thins. The supermarket at which I shop, by dropping the price of Triscuits to $2.77, will now be far more likely to sell me more boxes over time than it otherwise would because its sale prices will now be very competitive with Target's. And by putting the 8 oz. box of Triscuits on sale at a price that, quite frankly stunned me, it induced me to purchase more at one time than I ever remember buying before.

I, like many other people, have the expectation that prices in general will rise over time. I don't like the fact that prices seem to rise every year, but I do expect it. And why wouldn't people expect prices to rise over time, given the history of consumer prices in the United States?

When I suddenly saw the price of something I purchase on a regular basis plunge, it was because of my expectation that prices mostly rise over time that I reacted by buying more than I ever remember doing at one time. And it got me thinking about whether a temporary bout of deflation would be good for Americans. I realize the example of my Triscuits purchase involved far more than the 1% deflation I mentioned earlier in the article. But it brings up the following point: If society were to experience a one-time adjustment lower in prices, while everyday people maintained the expectation that prices would continue to rise over time (from the new lower point), it might actually induce more buying. Under that scenario, I, for one, would be buying products hand over fist.

I am certainly not advocating the government adjust prices by dictate. But companies that choose, perhaps on a brand-by-brand basis, to make those types of adjustments might be surprised by the resulting increase in demand for their products. We are currently living in a low-growth world that for many people brings with it negative real wage growth. It is therefore not surprising that companies are using "stealth inflation" in addition to nominal price increases as a method of pushing through the total rise in price per unit sold (see article on stealth inflation, linked above).

To illustrate the negative pressure on compensation in recent years, the chart below shows "real" compensation per hour since the stock market bottomed on March 6, 2009. Real compensation is the ratio of total compensation to total hours worked, adjusted for inflation. Notice the lack of upward pressure on "real" compensation.

Naturally, I don't expect companies to adjust prices downward any time soon. After all, it would likely result in a massive drop in the stock market as investors initially panic at the prospect of lower revenues. And, as we've come to learn in recent years, corporate executives and government policy makers tend to do whatever they must not to anger stock market investors. But nevertheless, it is a fascinating thought experiment that deflation itself might not cause a reduction in demand, as so many are taught to think. Instead, I would contend that from an end-consumer point of view, it is persistent and aggressive expectations of deflation that might reduce demand. But it would truly have to be persistent and aggressive expectations of deflation. An everyday American, in my mind, is simply not going to delay purchases of most items because he or she expects the price to be 1% lower in a year.

Moreover, if certain input costs were to decline in a deflationary environment, it might help to temper the initial hit to revenues that corporations would suffer from price declines. Of course, in a world in which inflation expectations and rising asset prices are a top priority of central bankers, any hint of price declines might bring with it even more quantitative easing. But perhaps central bankers should consider the long-term effects of their actions on the equity portfolios of tens of millions of everyday investors. We hear a lot about how the Fed is harming savers with its ultra-low-interest-rate policy. I think the Fed is also not doing long-term investors any favor by helping to prop up asset prices today.

Millions of everyday Americans invest in the stock market on a regular basis, regardless of price or valuation, when money is pulled from their paychecks every couple of weeks and put into a defined contribution plan. In light of the manner in which millions of Americans invest and how the stock market behaves (takes the stairs up and the elevator down), dollar-cost averaging into QE-influenced bull markets doesn't help anyone over a multi-decade period, assuming QE's influence on asset prices won't last forever. Wouldn't you rather have had a couple of years of lower, non-QE-influenced stock prices, thereby affording you the opportunity to purchase more shares on a continual basis at prices that thirty years from now may look incredibly low? But the equity market doesn't provide those opportunities. Instead, the typical American investor only gets a short period of time to contribute into a falling market before prices turn and head upward again. This is especially true for those investors who only contribute once per pay period.

Take a look at the following chart of the S&P 500's performance since the bear market bottom in 2009. I know we are constantly reminded about how well our money has performed since 2009, but remember that every contribution you made over the past four years didn't occur at the bear market bottom. Everyday investors contributing to a retirement plan every pay period have been averaging in at ever higher prices. I know I would have loved a few years of equity prices hanging out at much lower levels, giving me time to accumulate even more shares. But that is not how things work in the world of QE.

In Chapter 9 of my book, The 5 Fundamentals of Building a Retirement Portfolio, I examine the equity performance of a typical retirement investor's portfolio during a time in which stocks rose an incredible amount over many years (beginning at the bear market low in 1982). I did this in order to see whether averaging into a raging bull market works over an extended period of time. The results will likely surprise you. I contend that a period of several years in which equity prices remain depressed would be a great thing for investors with long time horizons. So from an investment perspective, a little deflation in the short-term might not be a bad thing over the long term.

Regarding your personal situation, do you think a little deflation would make your life better or worse? Think about this from both an investment and non-investment perspective. Would lower costs for the things you need be a good thing for you? Would it cause you to delay your purchases of various items? When thinking about your investment portfolio, don't forget to consider the effects to your portfolio of buying into weakness for a period of time during which the economy and financial markets adjust to a world dominated by organic demand rather than ultra-easy-money-induced demand.

I don't pretend to have all the answers about how companies can increase revenues, how the financial markets can be weaned from QE without major disruptions to asset prices, or how consumers will react to rising or falling prices. But I do know how I react to rising and falling prices. And I know how a lot of other people I associate with react to rising and falling prices. From my life experiences, I have a hunch that falling prices (whether one-time adjustments lower or slow adjustments over time) might not be as catastrophic as people are led to believe.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.