Death by deflation

The eroding effects of inflation have given it the well-deserved title of 'silent killer'. But with deflation now so widespread across the world, can it be equally dangerous, asks Claire Bennison

In the investment world, inflation is often referred to as a 'silent killer'. It is defined as an increase in the general price level (i.e. goods and services becoming more expensive over a certain time period). But why is it recognised as a silent killer?

If we look at retirement savings as an example, an investor saves and invests to gain a return they hope will meet future objectives and expenditure needs. However, if inflation is hard to forecast and the outlook is uncertain, investors find it difficult to ensure that their future purchasing power isn't significantly harmed. This is one of the reasons investors look to be adequately compensated when purchasing risk assets.

For example, if inflation averages 2.75 per cent for the next 25 years (as it did for the previous 25) you would need to have saved £2.26m during those 25 years to have the same purchasing power of £1m in today's money. Clearly, inflation and its effect are not to be underestimated.

Lessons from Japan

Deflation is the decrease in the general price level, as goods and services become cheaper and the real value of money increases (consumers can buy more). So what's the concern?

Deflation worsens the position of debtors by increasing the real value of debt and also has an adverse effect on consumer spending. The theory is that consumers delay spending in the near term as they anticipate being able to buy the good more cheaply in the future.
This puts pressure on consumer spending and can create a deflationary downward spiral which harms growth, as was seen in Japan during the 1990s.

After a period of exuberant lending and asset price inflation, the Bank of Japan moved to curb speculation and keep inflation in check by raising lending rates. A sharp fall in the price of equity and property markets shortly followed, with the country suffering years of volatile economic growth and long periods of falling prices.

Europe

The eurozone's inflation rate turned negative for the year to December 2014 and the threat of a prolonged period of turmoil in the region has seen comparisons drawn with Japan. Eurozone Consumer Price Inflation (CPI) was minus 0.2 per cent; the first negative reading since 2009. However this was primarily due to the rapid fall in the price of oil. So the region may not be experiencing 'true deflation'.

The European Central Bank (ECB) has previously described certain conditions it believes are necessary to justify the term deflation. This includes a generalised and persistent lowering of prices, which can be associated with a "decline in aggregate demand".

Nevertheless, despite core inflation in the area remaining positive for the time being, the inflation outlook remains weak and below the ECB's target rate of 2 per cent. With a muted growth outlook and stubborn unemployment rate of 11.5 per cent (more than double the rate of the US) consensus opinion is that the ECB needs to act soon. Certain commentators have also argued that pursuing austerity measures whilst facing recession, and a lack of action by the ECB to date, has also hurt the region and increased deflationary pressures.

With Quantitative Easing (QE) largely expected to be confirmed at the ECB's meeting on 22 January, policy makers will be hoping that a significant injection of funds will create plenty of liquidity and stimulate inflation and growth. They'll also be hoping that devaluing the euro will make exports more attractive.

However critics say that QE alone will not save the Eurozone, arguing that structural reforms in individual nations and relaxing fiscal constraints is what's needed to revive the idiosyncratic economies throughout the region. While the outcome of QE in the eurozone remains uncertain, officials now have little option but to act swiftly, and all will be hoping that the effects are similar to those witnessed in the US and UK over recent years.

Claire Bennison is regional director at Brooks Macdonald in Manchester

She writes a regular in-practice article on asset management for Private Client Adviser