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Inflation, deflation—how about MEflation?

Wayne Farlow //September 16, 2010//

Inflation, deflation—how about MEflation?

Wayne Farlow //September 16, 2010//

Lately, there has been considerable press about how the US is on the precipice of deflation, where prices, wages and asset values decline. However, with food and energy prices rising and health care costs continuing to increase, it is hard to see any deflation.

Recently, an economist explained this apparent paradox in a manner that I could actually understand.. From his perspective, while most of our everyday costs continue to increase, a significant amount of deflation has already occurred through our most valuable asset, our homes.

As most homeowners know, the price for which we can sell our home is less than it was in 2006. To make matters worse, our financial institutions, including the Fed, still have trillions of dollars of “toxic mortgages” on their balance sheets. These mortgages are carried on their balance sheets at their original values. As mortgages are ultimately forced into foreclosure, more downward pressure will be placed on the value of our homes.

For many of us, our most valuable single asset is the equity in our home. As the value of our home declines, we experience financial deflation, even though our consumption costs (food, energy, health care, etc) continue to rise.

If financial institutions are allowed to continue to carry toxic mortgages on their books, at values above their market value, we will likely suffer the same economic malaise as Japan has experienced over the past 20 years. Over time, this economic malaise will depress the value of other financial assets, including the stock market, and could lead to economy wide deflation. If this occurs, the only mechanism available to the Fed and US Treasury to “salvage” our economy from deflation would be to drastically devalue the dollar. If those measures are taken, they could produce runaway inflation.

Since there seems to be no political will to address the core cause of our nation’s financial and economic malaise, let’s look at some ways that you can protect yourself regardless of whether we experience inflation or deflation.

In a recent Wall Street Journal article, Jason Zweig used the term “Meflation.” He defines meflation as the direct, personal impact of the changing cost of living on your investments, your budget and your labor income.

Meflation requires that you first determine whether inflation or deflation is a greater personal financial threat. A younger person, with good future employment prospects, a stock portfolio and a home with a fixed rate mortgage, faces much greater financial damage from deflation than inflation. However, a retired person, living on a fixed income, could actually benefit from deflation, as prices would fall while their pension and or social security benefits would remain constant.

Meflation suggests investing to protect against whichever future cost of living direction (inflation or deflation) creates your greater financial risk. While it may appear counterintuitive, the best investment strategy for a younger person, who will prosper more with inflation than deflation, is to invest in assets that do better in deflationary times.

Japan has experienced deflation since having a similar financial crisis in 1990. Over this 20 year period, stocks have had an average annual real rate of return of -6 percent, while long term bonds have increased by an average of 5.3 percent annually. The accepted investment “wisdom” is for a younger person to put a large percentage of their investment portfolio into stocks. However, since a younger person will often prosper in inflationary times, they can better protect their assets by holding more bond funds, which may perform better than stocks in deflationary times.

Conversely, a retired (or soon to be retired) individual or couple, for whom inflation poses the larger financial risk, should invest in Treasury Inflation Protected Bond funds (TIPS) as well as a well diversified portfolio of financially sound, dividend paying stocks. A small amount of the portfolio should also be in gold and/or Real Estate Investment Trusts (REITS) which often perform well in an inflationary environment.

No one knows whether the future will hold inflation, deflation or both. A “meflation” approach, in which your investment strategy provides protection against your more financially harmful scenario, can help you weather the financial storm, regardless of its direction.
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Wayne Farlow is the founder of Financial Abundance, LLC, providing fee-only financial planning, asset management and retirement planning services. He is the author of “Financial Abundance Guide,” available free at www.finabguide.com . He can be reached by email at [email protected] or at 303-554-0309.