This article was posted on Monday, Apr 01, 2019

Continued from Part 78 . . . Lending – Notwithstanding the potential for inflation-related losses, there are many reasons to buy bonds. An obvious example might be when a major expense is expected in a couple of years (grand-daughter’s wedding, etc). The investor has the money now, but doesn’t want to put it into stocks because the market may be down when the debt is due. In that case, putting it into bonds makes sense. Her losses will be minimal and she’ll have the funds when they are needed.

Or, given that her stock portfolio backs up her income property portfolio, she recognizes that bonds could be used to back up her stocks. She’s willing to exchange a minor loss to inflation for the security that near-instant access to cash represents . . . and for the ability to draw on her bond portfolio to buy stocks when they are down.

Other reasons will occur. The point of this discussion is not that bonds are never useful. The point is that there’s seldom much net yield left after deductions for taxes and inflation. There are times, though, when that is an acceptable position.

The “Cant’s”: The thoughtful borrower recognizes she can’t expect to borrow institutional money at less than the current rate of inflation. It’s different from mommy and daddy. They’ll do almost anything to get her out of the house.

The “Can”: In our mortgage business we like to have our clients understand that if the trend in interest rates continues upwards, it’s probably better to refinance now than to wait and watch rates rise and refinance sometime in the future at an even higher rate. It’s possible that whatever interest charges are today will look really good in a couple of years.

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Definition: Inflation is a period of rising prices. Borrowers, certainly including the government, have an interest in maintaining inflation as their debts are repaid with ever-cheaper dollars. Thus, inflation will always be with us. It is a serious obstacle to growing wealth, but can be managed by owning assets that automatically adjust to inflation. Managing inflation is largely an asset selection issue.

If the assets are borrowed against, the loan should have an acceptable structural limit (a contractual ceiling) on the interest rate.

The opposite of inflation is deflation, whose defining characteristic is that prices go down. Deflation is managed by purchasing assets at or near the bottom of the deflationary period: it’s a timing issue.

Kinds: There are two kinds of deflation: beneficial and dreadful. Both involve the lowering of prices, but when they happen and what their economic effects might be are very different.

Dreadful deflation occurs most often following a long period of uber-low interest rates. Eventually the inflection point is reached, rates start to climb, and nobody can breathe anymore. To have rising rates in a leveraged economy is particularly synergistic.

Beneficial deflation comes in two forms: general (an overall price decline affecting most economic sectors) and specific (a price decline that affects a single industry). Beneficial deflation most often happens in a stable interest rate environment.

General price declines don’t happen very often, but when they do they can foreshadow a period of strong economic growth. Price reductions confined to a few specific industries are much more frequent.

1880 – 1920: Beneficial deflation reveals itself through lower prices during a period of stable interest rates. The last time the larger economy had a beneficial general price reduction (and increased demand) was during the Second Industrial Revolution (1880-ish to 1920-ish). The softening prices were due to pivotal inventions like the Bessemer process, which retired the crucible method and provided for greater steel production; the telegraph and later the telephone; the expansion of railroads, and interchangeable parts making production lines possible.

During this heady period of cheaper prices interest rates were accommodative, but not submissive. The 10-year Constant Maturity Treasury Yield ranged from 3.5% (1880) to 4.5% (1920) Source:

Material: The Bessemer process (and the later open hearth furnace) provided for widespread price reductions as steel (now ever-cheaper) was used in nearly everything. Even if it was not physically present in wooden salad bowls, steel was needed to make the tools that made the bowls. As another example, cheaper steel contributed to the ever-declining cost of Henry Ford’s Model T. The car cost $900 in 1910 (inflation adjusted value: $24,000) and incrementally reduced over the following 15 years to $260 (inflation adjusted value: $3,700).

Data: The telegraph and later the telephone facilitated manufacturing efficiencies. Mr. Ford could be advised of important changes more quickly than previously and in time to do something about it:  (Phone rings. “Your steel order will be late, Henry. We’re overbooked”) and appropriate changes could be made (“Sam, take your crew off the riveting line and put ‘em to work in the paint shop”). Timely data leads to efficiencies that were later reflected in prices.

Railroads: Whereas previously ore was carried in small lots by wagons drawn with draft mules, railroads were now moving car loads of iron ore from Michigan’sMarquetteRange to the steel plants west of Detroit. They did it both faster and cheaper, but some think less picturesquely, than mule-trains. Thus began an early form of the just-in-time supply chain, yet another kind of efficiency.

Assembly: And suddenly there were interchangeable parts. Complex products that previously had to be built one piece at a time, with skilled craftsmen carefully fitting the parts together with hand files, emery cloth, and myopia were manufactured afterwards to common dimensions. This removed fitting from the manufacturing process and replaced it with much quicker assembly.  Lesser-skilled workmen could do that work. It’s another savings.

The shift to dimensioned parts made the production line possible. It was yet another contributor to the retail cost of Mr. Ford’s Model T being reduced at nearly a 12% per year (compounded) decline for a decade-and-a-half.

1965-ish: In the early 1960s a gigabyte of computer memory was only a wonk’s fantasy. Then an unlikely decision was made by a mid-level executive inSan Jose, and by 1966 a hard drive with a full gig of memory could be ordered. It cost $1,000,000 (inflation adjusted value: $8,333,000).

This was a pivotal event, similar in some ways to Roger Bannister’s breakthrough 3:59.4 mile on May 6th, 1954. The four-minute mile had been approached, but never before broached, and was considered by some to be beyond human capacity. Then Sir Roger did it, and suddenly everyone rethought their limits. It did not take long before another runner did it, then someone else. It is still not commonplace, but it is no longer a shock. There have been more than 500 sub-4’s run since Bannister, with 21 just during 2018. Just so, once it became known that it was possible to purchase memory by the gig, other IT people began competing and the price started down, slowly at first but later hyperbolically. It required massive infusions of capital, but the capital was available. The CMT was at 4% in 1966 and at 4.5% in 2005.

As the price per gig declined it became cost-effective to use computers in applications never before considered. Now, 55 years or so on, computer memory is about 2 cents a gigabyte and we’re in the internet-of-everything. Even doorbells are computerized.

Reynold Johnson, a former high school science teacher and subsequently the lab supervisor for IBM inSan Jose, was responsible for the decision that made this industry-specific deflation possible. Previously, the magnetic tape used by mainframe computers had large capacity but the information was slow to retrieve. The alternative, drum memory, offered quick access to data but at the cost of restricted capacity. Reynold Johnson was the guy who hybridized tape with drum when he decided that henceforth computer storage for IBM mainframes would be on spinning disks. This resulted in the world’s first hard drive and that eventually reduced computer storage costs to where they are today. Reynold Johnson made possible the internet-of-everything.

Beneficial: Beneficial deflation reveals itself through price declines, either generally (the Second Industrial Revolution) or specifically (e.g., ever-lowering prices for computer memory). Deflation is thought by Those-Who-Consider-Such-Things to be disastrous to the economy. History shows that it doesn’t have to be. Once past the awkward transitional period when mule-skinners learn to be locomotive engineers, the lowering of prices, whether general or specific, results in higher living standards for nearly everyone.

In both examples of beneficial deflation the key element was an active credit market stable enough to encourage long term planning. Sound planning led to production efficiencies, which in turn provided for increased supply. As supply grew, competitive demand pressures drove the lowering of prices, and this resulted in more sales, which in turn generated higher employment and more tax revenue. Overall, beneficial deflation is a Very Good Thing.

Dreadful: But sometimes the credit market is non-supportive and things turn out quite differently, occasionally all the way to dreadful. In extremis, the credit markets fail the economy and the result can be a deflationary spiral. Escape is painful. A deflationary spiral is “a downward price reaction to an economic crisis leading to lower production, lower employment, decreased demand and still lower prices.” It’s a type of uroboros, where the economic dragon consumes its own tail through less investment borrowing, lower production, and decreased sales. Both employment and tax revenues sink. In these ways a dreadful deflation is the reverse of what we saw in the two examples of beneficial price lowering.

The economic cycle is defined by interest rates. A lowering of interest rates in the back half of one cycle is followed by their subsequent rising in the first half of the next rate cycle. The good part comes first: stimulative low rates drive investment prices higher. Investment owners are happy and buyers are hopeful.

But when interest rates get a cold, asset prices get pneumonia. To illustrate, if rates were 8% and a prospective purchaser could afford a monthly home payment of $500, he would be able to service a $68,000 debt over 30 years. But if rates became stimulative and incrementally ratcheted down, to say 2%, that same $500 house payment would service a much higher debt of $135,000. Nothing changed except the timing: the point on the interest rate cycle when the loan was made. When rates are low, prices are high. When rates are high, prices are low.

Rates predictably reverting from low levels to (or above) their mean can drive payments on variable debt to unaffordable levels. Ever-larger monthly payments to service debt on things already owned threatens repossession / foreclosure and resale of consumer items at bottomless sale prices. Unlike new items which have a price floor (the sunk costs of capital, materials, labor, shipping, taxes, etc), used items have no price bottom. The sunk costs were recovered at the original sale. The used item now has no theoretical bottom, as buyers of “short-sale” properties during the Great Recession (2007 – 2009) can attest. As an example, Forbes Magazine (Dec, 2010) referenced Florida condominiums in West Palm Beach and Boca Raton going for as little as $8,500.

In a “bad” deflationary period, costly new goods must compete directly with pre-owned items, generally to the detriment of the expensive new goods. The results are closed businesses, unemployment, repossessions, and foreclosures. Examples of economies giggling their way through the shadows areAmerica’s Great Depression (1929 – 1939), Hong Kong (1997– 2004), and Japan(begin: 1989). The collapse of an advanced economy’s debt-bubble and subsequent consumer-induced deflation has happened many times before. Dreadful deflation is part of the long term credit cycle. It is where (now) unaffordable debt goes to die. It can and will happen again, but it can be managed: deflation is a timing issue.

This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. Klarise Yahya is a Commercial Mortgage Broker specializing in difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate Klarise Yahya can help. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].