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Tuesday, 14 June 2016

Market myth #2: Deflation to cause the end of days

Market myths

Property market commentary has become infused with a tsunami of theories as to why the world is ending. 

Some represent credible threats, of course.

Others represent no such hazard, yet have been espoused so frequently they are increasingly being treated as common knowledge. 

When "everyone knows" something it's often a good time to consider whether "everyone" might just be wrong.

I'm going to look at a number of common myths in the next few weeks, and today it's...

Deflation to cause the end of days

Japan famously began to experience punishing deflation in the early 1990s, a problem exacerbated by its aging population and a range of other factors, including a lack of decisive action to correct it.

Apparently, Australia could be next - or so we keep hearing - despite the fact that since Japan's experience has meant that governments and central banks would sooner drop money from helicopters than go through the same pain.

The truth is that nobody can accurately predict the future, so you have to make your own call on this one, and go with the balance of probabilities.

If you believe that deflation is coming the smart thing to do would be to sell up all of your assets - your home, your shares, your superannuation - and get into cash, safe in the knowledge that goods and services will keep getting cheaper and cheaper and cheaper over time, year in and year out...and your money will be worth relatively more and more into the future.

Personally I reckon that's a pretty silly idea, but as noted you really do have to make your own decisions on this.

Do you reckon stuff will be cheaper in 2026? And cheaper again in 2036? And 2046? I reckon you need your head read if you believe so, but only you can decide.

The silent thief

Below I've plotted the all groups Consumer Price Index (CPI) figures for Australia's five most populous cities for the 68 years since 1948.

Actually, Adelaide did see prices fall a bit in the first quarter of 2016, but the long run trend has been up, up, up and away. 

Now you might say that the price of stuff wasn't rising that much in the 1950s and 1960s - but this is partly an illusion as I've deliberately plotted the chart on a linear scale rather than a log scale to underscore a point. 

(In fact prices broadly doubled between 1952 and 1972 - the gains just look less when measured in today's dollars, which is one of the deceptive aspects of cumulative price increases).

I've used a linear scale so that so you can see the effect of compound interest - the CPI indexes are about 30 times higher than they were in 1948, just 68 years ago.

Which is to day, a basket of goods and services costs about 30 times more than it did in 1948.

Since the introduction of inflation targeting in 1991, prices have increased more steadily, up by about 28 to 31 per cent in the largest cities over the last decade. 

Two considerations

There are a couple of things which you might wish to consider about inflation.

Firstly, "inflation" is not just some amorphous blob - the indexes are designed to measure the quarterly and annual change in the price of a 'basket' of goods and services, aiming to represent a high proportion of expenditure for metropolitan households.

The first thing to consider is that not all things are getting more expensive, but some things definitely are.

When was the last time you had a doctor's bill that was cheaper than from the year before, for example? Never happens, huh. Same for many pharmaceuticals.

Yet other stuff has gotten relatively cheaper over time, most notably clothing and footwear, and, by way of another example, the real quality-adjusted price of new motor vehicles.

So even if inflation was stone dead flat - or even if we were experiencing deflation - some things would be getting more expensive, and some wouldn't.

Here's what happened over the year to March, for example.

I believe that since the things you are likely to need most in retirement including housing, health care services, and pharmaceuticals are likely to be much more expensive in the future, hoarding cash may not be such a great idea due to inflation risk.

A second consideration worth noting that if you live to be 65 today, you might reasonably expect to live for two decades beyond the traditional retirement date. You might even live for three decades.

Even in today's lower inflation environment the price of goods and services could feasibly double over such a time horizon, destroying the purchasing power of your cash.

Which means that even after retirement moving your asset allocation into the so-termed "risk free" assets like bonds and cash might not be the best idea.

Remember, the inflation-targeting Reserve Bank of Australia (RBA) is mandated to maintain consumer price inflation between a range of 2 to 3 percent, on average, over the medium term.

And when inflation dips below the target range or looks set to - as happened recently - the the RBA will have little hesitation in cutting rates until inflation in the target range returns.