Reflation: What is it, and why you need to understand it

Reflation is an important term for investors to know. It is important to understand where we are in the business cycle as it can affect the performance of your share portfolio. In this article, we discuss what reflation is, how it is implemented, and the sectors which profit from these economic conditions.

What is reflation?

Reflation is a deliberate attempt to raise the general level of prices to achieve an economy at full employment and growth. In Australia, the Reserve Bank of Australia (RBA) tries to achieve an inflation target of 2-3% a year. When this level is not achieved, then the government will attempt to obtain this level through various measures. The purpose of these methods is to encourage consumers to spend money to purchase goods and services, and to put funds back into the economy.

Reflation occurs when the price level is increased to return to the long-term trend. Reflation is higher inflation, but to restore the economy to the targeted level. It is different from inflation as that occurs when it is above the long-term trend. In this case, governments would then need to slow growth down to get the general level of prices down.

How can governments do this?

Governments can create reflation by lowering the interest rate, reducing taxes or changing the money supply, or increase spending on infrastructure. The main purpose is to encourage consumers to spend more money by implementing these strategies that leave more money in their disposable income.

Why is it important?

Investors should take note of reflation so they can alter their share portfolios accordingly. It is important to know where the economy is at, as it affects the spending patterns of goods and services from consumers. This can then lead to different share price performances of companies.

What stocks do well in reflation?

One of the goals of economic expansion is to increase wages growth. When economic growth occurs, then the labour market becomes competitive and companies need to increase wages to attract new hires. This leads to more consumer spending and economic growth. Reflation occurs when there is strong growth and rising inflation which can lead to higher interest rates. Sectors that do well in rising growth and inflation include resources stocks, banks, and value stocks.

Resources would do well in reflationary conditions as it is a cyclical stock and these stocks perform better in a higher growth environment. Banks also perform well as increasing interest rates can lead to higher interest margins, which banks can profit from. Stocks with low price to earnings should then go on to outperform growth stocks. Value stocks do well in periods of economic recovery.

What is the between deflation and reflation?

Deflation is when the general price level is declining. Governments try to avoid this as falling prices will discourage consumers from purchasing goods and services as they expect the prices to go down further. This can cause a decline in economic growth. Reflation means to stop general prices from falling by stimulating the economy and encouraging consumers to buy now.

Lauren Hua is a private client adviser at Fairmont Equities.  

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