Inflation occurs when prices for goods and services increase, while deflation happens when prices decrease. Sustained periods of sizable inflation or deflation can have significant effects on the economy and on the behavior of investors, businesses and consumers. Government policymakers and ordinary people keep a close eye on measures of prices in order to help them make decisions that will keep the overall economy and individual personal finances healthy.
A financial advisor can show you how to prepare for both inflation and deflation.
The most widely used measure of inflation in the U.S. is the Consumer Price Index (CPI), which is calculated each month by the Bureau of Labor Statistics (BLS). The BLS examines how prices paid by urban consumers for a basket of goods and services change over time. The CPI is broken down by regions as well as being reported for the country as a whole. The CPI also reports prices for specific purchases such as gasoline, food and utilities.
Inflation and Deflation Effects
Inflation and deflation are connected to economic cycles. During economic recessions, demand generally slips so that prices fall, leading to deflation. Wages and employment also tend to decline under the pressure of deflation as economic activity slows. Interest rates may fall as borrowers avoid taking out loans.
When the economy is growing strongly, demand for goods and services increases and that leads to higher prices, which means inflation. Over time, inflation reduces the purchasing power of money. During a period of inflation, a dollar is worth less from one year to the next because it will purchase less. Wages also tend to rise during inflation, however, so workers earn more. Borrowing tends to increase, since debts can be paid back in the future with dollars that are worth less.
The U.S. experienced a period of rapid deflation during March 2020 as the COVID pandemic and associated business closures, layoffs, lockdowns and reduced economic activity pushed the economy into recession. But a year later, however, inflation as measured by the CPI had come back strongly and the economy was expected to enter a period of sustained expansion and rising prices.
Investor Responses to Inflation and Deflation
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, so the value of a portfolio declines over time. 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 deflations, there is 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.
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.
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