What is Deflation?

Deflation is the opposite of inflation. It is the decline in prices for goods and services, typically associated with a contraction in the supply of money and credit in the economy. Let’s break that down. If the Federal Reserve wants to contract or reduce the amount of money consumers have to spend, they increase interest rates. As a result, consumers do not borrow as much money resulting in fewer purchases which increases inventory causing prices to drop in order to move merchandise. On the surface deflation may sound like a good thing as your money buys more stuff but if deflation persists, it often leads to job loss and reduced economic activity.

In the past 60 years, the US has experienced deflation only two times; once in 2009 and again in 2015. During periods of deflation, you may want to stay away from risky investments like stocks and corporate bonds. Investing in the stock market carries more risk during a period of deflation because if merchandise isn’t selling revenues drop which in turn puts pressure on the stock price. Furthermore, if revenues drop corporations may not have the cashflow necessary to properly service their debt (pay bondholders their interest payments). Holding more cash or investing in gold, silver, and Treasury bonds can be a prudent strategy.

One of the main jobs of The Federal Reserve is to strike a balance; meaning too much of either inflation or deflation is a bad thing. This is why you see interest rates move around. When the feds want consumers to spend more money, they reduce rates which encourages us to borrow/spend. When the feds want consumers to spend less money, they raise rates discouraging us from borrowing/spending money. What I have just described is our Monetary Policy; a Monetary policy is a set of actions available to a nation’s central bank to achieve sustainable economic growth by adjusting the money supply.