Inflation vs Deflation: How It Affects Your Finances

Inflation refers to the rise in prices for goods and services, while deflation describes a decrease in prices. Prolonged periods of significant inflation or deflation can profoundly impact the economy, influencing the decisions of investors, businesses and consumers alike. Both government policymakers and individuals closely monitor price trends to make informed choices that promote economic stability and safeguard personal finances. But as an investor, it’s still important to know how inflation vs. deflation can affect your finances.

A financial advisor can show you how to prepare for both inflation and deflation.

Inflation and Deflation: The Effects

In the U.S., the Consumer Price Index (CPI) is the most commonly used measure of inflation. Calculated monthly by the Bureau of Labor Statistics (BLS), the CPI tracks changes in the prices that urban consumers pay for a representative basket of goods and services. This index is reported both nationally and regionally, and it also highlights specific categories like gasoline, food and utilities.

Inflation and deflation are closely tied to the economic cycle. During recessions, falling demand for goods and services can lead to declining prices, a phenomenon known as deflation. This often results in lower wages, reduced employment and decreased economic activity. Borrowing also slows as consumers and businesses shy away from taking on new debt, leading to lower interest rates.

Conversely, during periods of strong economic growth, rising demand drives prices higher, resulting in inflation. Over time, inflation erodes the purchasing power of money, as each dollar buys less than before. However, wages typically increase during inflationary periods, providing workers with higher earnings. Borrowing activity also tends to rise, as future repayments become less burdensome due to the diminished value of money.

A recent example of these dynamics occurred in March 2020, when the onset of the COVID-19 pandemic caused a sharp deflationary period. Widespread business closures, layoffs and reduced economic activity plunged the U.S. economy into a recession. By the following year, however, inflation rebounded significantly, as measured by the CPI, marking the beginning of a sustained period of economic expansion and rising prices.

Investor Responses to Inflation and Deflation

A couple consider the rising price of groceries due to inflation.

During periods of high inflation, interest rates often increase. However, investors may limit putting money into bonds, certificates of deposit, money market accounts and bank savings accounts. That’s because these vehicles generally pay rates of return that are below inflation. This means the value of a portfolio would decline. Instead, investors during inflationary times seek protection from the decreasing value of money in:

Stocks – Equities have historically produced returns in excess of inflation.
Treasury Inflation-Protected Securities (TIPS) – These are U.S. government bonds that at maturity will pay investors either the original principal or the principal plus inflation. You can buy them individually or in a fund.
Real Estate Investment Trusts (REITs) – These are publicly traded securities that represent ownership of real estate assets. Real property prices rise with inflation, so REITs are often part of inflation-hedging strategies.
Commodities and precious metals – Gold, in particular, is used as an inflation hedge.

During deflationary periods, there’s more money circulating than there is demand for goods and services, which pushes prices down. During deflation, people may delay purchases in the expectation of being able to purchase items in the future for less than they cost now. This can further depress prices, wages and employment, creating a deflationary spiral.

When investors are hedging against deflation, their portfolios tend to include fewer equities and hard assets, such as real estate. Instead, they are more likely to put their money into financial instruments, including:

Bonds – Interest rates generally decline during deflations, so a fixed-rate corporate or government bond paying a current market rate of interest will be paying above-market interest in the future.
Interest-bearing accounts – Investors are also more likely to stash cash in savings accounts and money market accounts, expecting that their dollars will buy more in the future if deflation continues.

Managing Inflation and Deflation

The Federal Reserve seeks to control inflation and deflation through monetary policy. The Fed aims for a long-term rate of 2% inflation because it’s thought this encourages maximum employment without spurring runaway price increases. Fed policymakers pursue this goal by selling U.S. Treasury securities when inflation is low in order to increase the money supply. It also may reduce the reserve rate banks pay to borrow money, which tends to reduce other interest rates and make it cheaper to borrow money for homes, autos and other purposes.

When inflation is high, the Fed may increase interest rates to make it more expensive to borrow money. This tends to dampen borrowing and demand, and ease the pressure to raise prices.

Bottom Line

Inflation and deflation are macro-economic trends that can significantly affect individual consumers, businesses and investors. During sustained high inflation, prices and wages rise and cash and fixed-income investments may lose purchasing power as the returns fail to keep up with inflation. During deflations, prices and employment may decline, along with wages. Investors hedging against deflation tend to emphasize fixed-income investments such as bonds, as well as interest-bearing accounts.

Tips on Financial Planning

Hedging an investment portfolio against inflation or deflation calls for accurately reading economic forecasts and selecting a balance of investments assets that will generate the best return under the expected conditions. SmartAsset’s free tool matches you with financial advisors who can help with this job in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
If your investments aren’t providing returns equal to or greater than the inflation rate, you’re probably in trouble. Here’s a free and easy-to-use inflation calculator that will give you a read on historical inflation rates.