Deflation

Deflation definition


The accepted deflation definition is an overall decrease in the cost of goods and services throughout the economy. Deflation results in an increase in the value of cash on hand due to the expanded buying power available with the same amount of money. Conversely, deflation magnifies debt both on the personal level and for corporations and governments who must now repay their obligations by giving up a larger chunk of purchasing power than was the case prior to deflation.

Deflation vs. inflation


Deflation is generally considered the direct opposite of inflation, and typically features high levels of unemployment, decreased wages, lowered interest rates, and reduced demand for the goods and services produced within an economy. Conversely, periods of inflation are characterized by increases in sales and in prices, higher interest rates, and increased wages throughout most of the economy.


Causes of deflation


Most economic experts attribute deflation to a decline in the demand for goods and services that forces manufacturers and retailers to reduce prices in order to move their products. This reduction in demand may be caused by catastrophic economic or political events or simply by an aversion to risk on the part of most investors in the market. When potential returns on investment fall significantly, investors typically move most or all of their available funds into low-risk Treasury backed securities or even into gold, silver, and other precious metals. This creates a scarcity of cash on the market, creating a credit crunch that can seriously impact the overall demand for goods and services within the economy.

Anatomy of a deflationary spiral


Short periods of deflation are normal, especially when they affect only a few sectors of the economy. Extended deflation, however, can create a reduction in the overall demand for goods and services as consumers and investors choose to stockpile cash rather than purchase new items. This reduces corporate profits and, in turn, creates pressure for wages to fall, reducing the spending power of the consumer class and further depressing the demand for goods. When this cycle of lessened consumer demand and falling wages becomes serious enough, it is known as a deflationary spiral. Typically, governments and centralized banking institutions use interest rate controls to manage deflationary cycles; however, as the interest rate paid on government securities approaches zero, the ability to effect change on the overall economy is also significantly curtailed. This can lead to a prolonged cycle that typically features extremely low interest rates, reduced demand for most goods and services, and cutbacks in salaries along with higher unemployment rates overall.

Keys to deflation investing


While most investors attempt to wait out deflation and conserve their available cash, there are a few deflation investing strategies that offer the potential for short-term and long-term profitability. These include:
  • Long-term Treasury bonds
  • Healthcare-based investments
  • New technologies, especially in the clean energy sector
These market sectors provide valuable protection to investors during deflationary periods. Long-term Treasury bonds allow investors to hedge against further declines in the overall interest rate, making them a perennial favorite among cautious investors. Healthcare and pharmaceutical investments do not significantly decline in value during deflation because the need and demand for healthcare is generally consistent and sustainable. Finally, new technologies offer high potential for profitability and, since many of these do not depend on market conditions for their funding, typically outperform other sectors during difficult economic times.
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