The Big “D”! Deflation- What is this and who cares if living is less expensive?
November 25, 2008
When it comes to the direction the economy is heading, the week ending 11/21/08 did end with some hopeful news. Federal Reserve President Jeffrey Lacker said that an economic recovery could begin in 2009 as low interest rates, low energy prices, and less drag from the housing sector may shore up spending. Stocks bounced higher on Friday, with the rally being boosted by the anticipated appointment of incoming Treasury Secretary Timothy Geitner. There was surprising news from the Fed last week that the “Minutes” from their October meeting revealed.
After years of being concerned about inflation, the Fed is now concerned about deflation. So what exactly is deflation? Deflation is when prices drop, which generally is due to lack of demand, and therefore lack of pricing power. With the economy slowing down, we are hearing economists forecast that we may be in for a deflationary recession. In a deflationary environment, investors flee into fixed instruments like Bonds, because the fixed payment received would actually buy them more goods and services over time as prices decline.
GOOD NEWS: So what does this mean for home loan rates? Remember, home loan rates improve as Bond pricing moves higher – and more demand for Bonds would mean higher prices for Bonds. In the spring of 2003, when Alan Greenspan uttered the “D” word, deflation, Bonds rallied in just a few weeks, bringing a significant drop in home loan rates. Of course, the economy is different right now, but as more money may be headed towards Bonds in a deflationary environment, we could again see a significant improvement in home loan rates down the road. Stocks could pull money out of Bonds and cause some short term worsening of home loan rates…but if deflation starts grabbing more headlines, smart money will be headed towards Bonds, which will help home loan rates improve.
IMPACT ON ECONOMY: Again, deflation occurs when the general level of prices falls. In the extreme form, prices of everything fall: goods and services, shares, houses and labor. That is what happened in many countries in the 1930s. It is what happened in the 1990s in Japan. The result is that deflation will hit profits severely and unless it is extremely mild or short-lived, it is bound to bring on a wave of insolvencies. In this way the deflation of prices can easily lead to the depression of real output and employment.
Question: We all want less expensive living. What do you think the long term effects (good or bad) of deflation are?
• Less Debt due to less spending?
• Harder to get qualified for home loans/credit?
• More businesses failing?
• Better Customer Service?
Megan McDonald, Licensed Mortgage Planner
Excel Home Lending
383 Inverness Parkway, Suite 140
Englewood, CO 80112
Cell: 303-717-9995
Fax: 303-468-6133
http://www.excelhomelending.com
http://www.mcdonaldlendingservices.com
Book Club Interactive: Utilize Meg’s Blog to discuss the Federal Reserve – What do you know about our monetary system? How does this system impact you?
Book: “The Creature from Jekyll Island”, G. Edward Griffin (4th edition/2008)
How Financially Savvy Are You? 
Love the blog – very informative, and clear enough even for the fiscally-challenged, like me.
Look forward to the next.
I can see why investors “flee” into bonds, but why would the Fed be so concerned about deflation (assuming it doesn’t last long-term)? I realize this is a pretty simplistic view, but wouldn’t it be viewed as a remedy for past inflation, and serve to basically balance out the economy a little?
Hey Megan,
Hope everything is well! I am so excited to see your blog! It’s very interesting 🙂
I think deflation in some areas of the markets is likely. As we’ve seen it happens right in front of our eyes (oil price, stocks, high-end retail). However, in other areas there probably won’t be much deflation. Basic food supply and daily necessities, for example, will see little price decrease. In fact, in a economic downturn, people actually consume more food. So it’s very much a supply-demand issue.
I am no pessimist, but I think the worst is still ahead. The deflation effect we are seeing in many asset markets are largely the fallout of the massive de-leveraging happening in the financial market. Many Large Funds just have to liquidate in order to keep the value of their devalued stocks up to the percentage required by law. So in other words what’s happening now is partly due to government intervention. But who would have thought back in 2006 (The Good Old Days) we would see such massive intervention by the Feds any way? I think this “Bail Out” of forced liquidation is going to continue for a while.
Anyway I like what you write a lot! Stay Warm this winter and say Hi to Ronnie and Aimee when you see them 🙂
Paul