With all the talk of inflation lately, another economic phenomenon is quietly percolating just below the surface, and when it finally emerges, it will catch most people off guard.

That phenomenon is deflation, and while it comes with some benefits — the most significant being a reduction in the cost of goods and services throughout the economy, which can be a good thing when facing inflation, it also comes with risks. The most significant is that it forces a change in your investing strategies. This is because what works during inflationary periods does not work during deflationary periods. As most people don’t understand this, they get financially blindsided.

So while we’re all busy talking about the impact of inflation today, we also need to be aware of deflation and how it affects our financial strategies.

What is deflation?

Most Americans understand that inflation increases the costs across most or all of the economy. To be more accurate, inflation is a reduction in the purchasing power of the U.S. dollar, but that’s a matter of semantics. Deflation, on the other hand, is the opposite of that, where costs decline because the purchasing power of the US dollar increases.

Deflation is usually correlated with a contraction in the supply of money and credit, but prices can also decline due to increased productivity and supply and technological improvements. When the Federal Reserve raises interest rates to combat runaway inflation, it causes a credit contraction and a correlating decrease in asset values and the price of goods. 

Essentially, deflation causes the nominal costs of capital, labor, goods, and services to fall, but it’s important to mention their relative prices may remain unchanged.

On the surface, this benefits consumers because it can increase their purchasing power without an increase in income. While this may sound great, not everyone benefits. For example, deflation can harm borrowers, who are obligated to pay their debts in money that is worth more than the money they borrowed, as well as anyone who invested in assets based on the hope of rising prices.

What causes deflation?

The money supply causes both inflation and deflation. While inflation is caused by pumping money into the economy, like we saw during the 2008 housing collapse and the 2020 pandemic stimulus, deflation is caused by a tightening of the money supply. The central bank, also known as the Federal Reserve, controls this. Essentially, the formula is this—when the supply of money and credit falls without a corresponding decrease in economic output, then costs tend to fall. An oversupply of goods puts downward pressure on prices

It’s also worth noting that periods of deflation typically occur following long periods of artificial monetary expansion, which is exactly what America has been doing for quite some time. The last time we saw a significant deflationary period was in the 1930s after the Great Depression, but Japan faced it more recently in the 1990s.

How does deflation change your investing strategies?

As with inflation, deflation makes the overall economy more volatile, increasing your risk when it comes to investing. But the good news is that you can protect yourself by investing in more stable assets, like profitable rental properties, treasury bills, or gold. Now, if you’ve read any of my other articles, you probably know that real estate is always my top choice, and that’s because it can produce income whether the asset is increasing or decreasing in value. This asset class acts as a hedge against both inflation and deflation.

It’s essential to first, carefully evaluate a property to make sure that it’s profitable now, and then, if you need to replace a tenant, that it remains profitable at current market rates in your area. You should also consider any repairs that may need to be made in the next few years, get today’s pricing on those projects, and ensure it’s still profitable if you have to do one (or more) sooner than you had hoped. This is always important, but it’s exponentially more important in a deflation-driven, volatile economy.

If you’re carrying a heavy debt load, you’ll want to reduce or eliminate that debt as quickly as possible—especially variable rate debt. You may remember I mentioned earlier that debt becomes more “expensive” during deflationary periods, and that can put a heavy burden on your budget. On the other hand, don’t be afraid to take on debt during a deflationary period if you’re using it to purchase cashflow-producing assets like real estate. 

But you also have to look at how deflation affects other people too, because their economic behavior can impact the performance of your investments. For example, suppose your investments require your customer base to access affordable credit, as would be the case for large transactions like vehicles, large machinery, or real estate. In that case, you may need to adjust your strategy because underwriting guidelines tend to get tighter and interest rates increase during deflationary periods.

In other words, you need to reallocate your investments to the asset classes that perform better in the face of deflation. Still, you also need to look at the economy as a whole to identify the potential downstream effects that could create further investing challenges for you.

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Dr. David Phelps created Freedom Founders to help its members achieve the freedom they wanted in their lives by building the necessary financial foundation. He is a noted financial expert who is regularly cited by the media, and recently helped the FL Dept. of Education develop its new financial literacy curriculum.