We're scared of inflation but what about deflation?

While a constant concern since the GFC has been that easy monetary policies would cause surging inflation, it hasn't occurred. But what if we end up with sustained deflation instead?

Deflation refers to persistent and generalised price falls. It occurred in the 1800s, 1930s and the past 20 years in Japan.

But there is good and bad deflation. Good deflation reflects technological innovation, with falling prices for electronic goods a classic example.

However, falling prices are bad if they are associated with falling wages, rising unemployment, falling asset prices and rising real debt burdens.

The threat of bad deflation has increased thanks to falling commodity prices and lots of spare capacity globally, meaning companies and workers lack pricing and bargaining power.

However, a sustained bout of bad deflation is unlikely. While goods prices are at risk, services price inflation is relatively resilient.

Central banks are now aggressively easing monetary policies again in an effort to boost global spending and inflation.

More global monetary easing should help ensure global growth continues and in turn prevent a slide into sustained deflation. In Australia, we are further away from the deflationary precipice and the combination of the falling $A boosting import prices and more Reserve Bank rate cuts should help ensure we don't see it.

Were sustained deflation to take hold, it would favour government bonds and cash over equities, property and corporate bonds, as the latter would all be hit by weaker economic activity that is likely to accompany sustained price falls.

However, the most likely outcome is that inflation will remain low. This has several implications for investors.

First, returns from cash and bank deposits will remain low. Second, a bond crash remains as distant as ever.

The most likely outcome is just low returns from government bonds reflecting record low bond yields. Third, the low-interest-rate environment means that the chase for yield is likely to continue supporting commercial property, infrastructure and high-yield shares.

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