Deflation Defined & How to Handle It

You would think when the price of goods and services fall it would be a good thing – think again!

There has been a lot of talk about inflation being a concern for investors going forward.  I believe the bigger concern in the short-run is deflation!  Investopedia defines deflation as:

“A macroeconomic condition where a country experiences lowering prices.”

Deflation is the opposite of inflation which is characterized by rising prices. Deflation (just ask Japan) is a much more difficult problem than inflation because it is so difficult to control. At first glance, it would seem logical that deflation is a good thing.  After all, having goods and services become cheaper seems like everyone wins.  We all buy more…

However, this can become a severe problem when prices keep going down over a long period of time.  Why?  People refuse to buy now because they anticipate continued lower prices in the future.  This will weigh on companies’ profits, which typically begin to decline during deflationary periods.

So if people aren’t buying, it creates excess supply. This forces companies to sell their products and services even cheaper.  This then leads to a cut back on production costs, reducing employee wages, lay off workers, or even the closing of production facilities. This could lead to further increases in unemployment, a stifled economy, and a lack of consumer spending because of economic uncertainty.

During deflationary periods, stock prices typically begin a period to decline as people sell off their investments.  Bonds temporarily become more attractive until the government can find a way to increase consumer and business spending.

This traditionally can be done by decreasing interest rates to stimulate the economy. However, with rates so low, the government has very little room to go.  Usually when rates are this low, people spend rather than save (because rates are so low), but right now the uncertainty is causing people to save at low rates to provide emergency reserves.  Let’s also face the facts: with so many unemployed many are not spending or saving, they are simply surviving.

What Can You Do If Deflation Heads Our Way?

Let’s look at ten things you can do to survive deflation if it comes to fruition:

1.  Pay off your debts.

When you owe money, inflation is your friend as you can pay it off faster as assets increase. The opposite is true with deflation. Your debts get more expensive over time, because they take away more of your real income. So the less debt you have going into a period of deflation, the better off you will be. Look to pay off those debts with the highest interest rates first.

2. Keep cash on hand.

With low interest rates on CDs, money markets, and checking accounts, why save? If real assets are falling in value by two to three percent per year, then even cash at zero percent interest is appreciating in value compared with other things. Increasing cash also helps prepare for emergencies and other investing opportunities.

3. Resist the temptation.

People tend to overspend when they see bargains. Just because prices are low doesn’t mean you should buy things you don’t need.  If it’s something you were going to buy anyways it’s one thing, but resist the temptation to buy just because it’s “on sale”!

4. Don’t spend money before you get it.

Many people spend the “raise” or “bonus” before it comes in.  Spending money before you get it often results in spending more than you anticipated. Many assumed they would get a Social Security increase in 2010, but because inflation was so low, no adjustment came.

5. Plan for “no wage” increases.

Many expect cost of living and additional raises each year. In the current environment, wage increases are becoming less likely.  So if deflation sets in, employers may be forced to cut raises and even reduce wages.

6. Look for multiple sources of income.

As money becomes tougher to come by and companies become less likely to give raises, it’s all up to you.  Getting a second job, selling items on Ebay, starting a home-based business, or other forms of additional income can come in handy.  Always be looking to diversify your income stream.

7. Cut back on home improvements.

If you are improving the home for your enjoyment it’s one thing but hold off on improvements that you are trying to eventually get back as an “investment.” Deflationary periods are a poor time to put money into your home.

8.  Don’t have too much stock exposure.

Deflation usually accompanies a recession. This typically means the stock market as a whole will have poor results.  Opportunities still exist, but you have to be more careful during deflationary periods.

9. If you own stocks, look for companies that pay a dividend.

Stocks that pay dividends can be a hedge against the capital depreciation that comes with deflation. Though many companies have been reducing dividends over the last few years.

10. Buy more bonds.

With interest rates historically low, many investors find the low return on high-quality bonds and Treasury securities unappealing. But if deflation occurs, a low return suddenly looks pretty good because it protects principal and offers a bit of appreciation.

As you can see, deflation can be a dangerous repercussion from a recession.  It is quite likely we may see a brief to extended period of deflation.  The U.S. Government is trying everything they can to prevent a Japan-like deflationary situation.  If they fail, this will be devastating as it has taken Japan more than twenty years to recover.

If history is our guide, we should plan prudently and utilize the ten steps highlighted in this article.  It could save you thousands of dollars and protect the hard earned money the Lord has entrusted to you.   Though no one knows whether we will see deflation, inflation, or both, one thing is for sure, those who plan ahead, tend to come out best on the other side!