Every macroeconomics student quickly learns the lesson of the Great Depression–that deflation (an environment where prices in general are falling) is the gravest ill that can befall a country. Why? …for companies, deflation means continuously declining revenues. At some point, the firm can no longer meet its payroll. Eventually, it can no longer service, much less repay, any borrowings it may have. As the 1930s showed, deflation breeds widespread unemployment and corporate bankruptcies.
Second place on the list of bad things that can happen goes to runaway inflation (accelerating rises in prices in general), a malady common in emerging economies–and one the US experienced in the 1970s. The issue here is that no one knows what interest rates in the future will be–only that they’ll be crazy high. So no one, neither individuals nor companies, invests in long-term projects–because they can’t figure out whether they’re money-makers or not. Instead, everyone starts to shun financial assets in favor of buying and hoarding tangibles like gold or real estate, sometimes in a completely loony way, on the idea that they will rise at lest in line with the soaring price level.
When the US began to fight its incipient runaway inflation under Paul Volcker in the early 1980s, the question arose among academic economists as to what was the “right” level of inflation. The consensus answer: 2%. Not so close to zero as to say “deflation,” but low enough not to suggest “runaway.”
So 2% inflation became the holy grail of US, and global, monetary policy. It took the US twenty years to hit this target.
Over the past several months, I’ve been reading and nearing comments from lots of different sources that suggest that 2% may be the wrong answer. Not the academic world, of course. Two reasons:
1. The Fed has been perplexed at its inability to keep inflation at 2%. The number seems to want to gravitate toward zero, instead. This raises the specter of deflation, the sure-fire investment killer. So this tendency is bad.
2. For small businesses, which have been the biggest engine of economic growth in the US in recent decades, a 2% rise in prices + at best 2% real growth = a 4% increase in annual revenues. The first objective for most family-owned firms is to make sure that this year’s profits won’t fall short of last year’s. That’s because any shortfall is money out of their pockets, not simply a theoretical loss. Apparently, +4% in revenues isn’t far enough away from zero to create enthusiasm for taking the risk of investing to expand the business. Therefore, no capital projects, no new hires.
Two reasons are most often cited for the current slow growth in the US: hangover from the Great Recession and dysfunction in Washington that prevents growth-promoting fiscal policy from being enacted.
I think a consensus is beginning to form that there may be a third culprit–an inflation target that has been set too low and which has inadvertently mired us in a kind of Bermuda Triangle monetary situation that the Fed can’t extract us from by itself.
This implies fiscal policy may be the only cure for sub-par growth. Therefore, ineptitude in Washington, even if that has been the norm forever, is no loner as tolerable as it has been in the past.
If this is so, growth stocks will continue to outperform value names in a slow-growth economy–unless/until fiscal policy gives a helping hand.