Given that global economies are facing tough times, now would be a good time to revisit the concept of inflation and especially deflation, while looking at how you can use them to your advantage.
Inflation, when simply put, is when prices rise, and deflation is when prices fall.
The balance between the two economic conditions, opposite sides of the same coin, is delicate and an economy can quickly swing from one condition to the other.
So while inflation is essentially a measure of how quickly the price of goods in an economy is increasing, deflation is the speed at which prices for goods and services drop – occurring when the inflation rate fall below zero per cent.
Let’s now look at these increasingly relevant and relatable economic concepts in detail and how one can make the most out of them.
How inflation translates to consumers
Breaking it down logically, inflation happens when goods and services are in high demand, thus creating a drop in availability and being charged higher than usual.
There are a number of reasons why supplies can decrease – it could be a natural disaster that can wipe out a food crop, a housing boom can exhaust building supplies, and so on. Whatever the reason, consumers are willing to pay more for the items they want and manufacturers and service providers will want to charge more.
Inflation is often seen as a big threat, but in reality, inflation can be good or bad, depending on the reasons and level of inflation. In fact, a complete lack of inflation can be quite bad for the economy.
Inflation lowers your standard of living if your income doesn't keep pace with rising prices. Most of the time, it rarely does. But if inflation is around 2 per cent, then people buy things now before prices go up in the future. That can spur economic growth.
Even when it's mild, inflation always impacts your life.
The concept of inflation is broadly classified into two based on the underlying causes.
Cost-push inflation is when prices rise as a result of rising costs of production and raw materials.
Cost-push inflation is usually more temporary than other sorts of inflation and therefore central banks are more likely to leave interest rates alone if the cause of a high inflation rate is deemed to be cost-push.
Economists argue that short-term cost-push inflation often leads to long-term high inflation down the line, triggered by wage increases that come in response to the initial bout of cost-push inflation.
Demand-pull inflation is a type of inflation that occurs when aggregate demand grows rapidly, outpacing aggregate supply.
Major consequences of inflation
• Income redistribution: One risk of higher inflation is that it has a regressive effect on lower-income families and older people in society. This happens when prices for food and domestic utilities such as water and heating rises at a rapid rate.
• Falling incomes: With millions of people facing a cut in their wages or at best a pay freeze, rising inflation leads to a fall in incomes.
• Negative real interest rates: If interest rates on savings accounts are lower than the rate of inflation, then people who rely on interest from their savings will be poorer.
• Cost of borrowing: High inflation may also lead to higher borrowing costs for businesses and people needing loans and mortgages as financial markets protect themselves against rising prices and increase the cost of borrowing on short and longer-term debt.
• Risks of wage inflation: High inflation can lead to more demands for a pay hike as people look to protect their real incomes. This can lead to a rise in labour costs and lower profits for businesses.
• Business competitiveness: If one country has a much higher rate of inflation than others for a considerable period of time, this will make its exports less price competitive in world markets. Eventually this may show through in reduced export orders, lower profits and fewer jobs, and also in a worsening of a country’s trade balance.
• Business uncertainty: High and volatile inflation is not good for business confidence partly because they cannot be sure of what their costs and prices are likely to be. This uncertainty might lead to a lower level of investment spending.
How to protect oneself from inflation?
• Invest in inflation-linked bonds: There are an increasing number of inflation-linked bonds offered by the most government treasuries that provide built-in ways to protect yourself from inflation.
These automatically rise in value along with inflation. If you're anxious about inflation, you'll get peace of mind if you own some of these.
• Invest in gold: The price of gold is frequently used as a hedge against inflation, but gold prices are affected by a lot of other things as well. Since it's traded on the commodities market, it's more volatile.
As a result, its prices don't rise and fall with other asset classes. That makes it good for a diversified portfolio. That’s the main reason why you should invest in gold.
• Invest in stocks: On the other hand, the best protection is a well-diversified portfolio that includes stocks. The stock market historically outperforms inflation.
Despite the lack of confidence most people express about stocks, owning some equities can be a very good way to combat inflation.
Think of your household as a business.
If a company cannot properly invest its money in projects that will deliver a return above its costs, then it, too, will fall victim to inflation.
The basic premise of business success is that corporations will sell their goods at increasing prices, which will lead to elevated revenues, earnings, and inevitably, stock prices.
• Invest in commodity: Some of the best stocks to own during inflation would be in companies that can increase their prices naturally during inflationary periods. Commodity resource companies are one example.
Products like oil, grains, and metals enjoy pricing power during periods of inflation. The prices of these items tend to go up as opposed to, for example, the price of a computer, which is subject to manufacturer and distributor price adjustments.
Look to invest in businesses such as commodity firms or healthcare companies that possess the strongest profit margins and, generally, the lowest cost of production. Finally, never underestimate the value of dividends during periods of inflation. Dividends increase the total return of a portfolio.
• Invest in a home: When done for the right reasons, like buying a home to live in, real estate is always a good investment. Problems occur when a buyer's goal is to flip the property they just bought at a profit.
Although experienced real estate investors are able to find hidden values in properties, the average person should focus on purchasing a home with the intent of holding it, even if only for a few years.
Real estate investments do not typically generate a return within several months or weeks; they require an extensive waiting period in order for values to increase. As a home buyer, unless you're paying cash, you're likely to put some money down and take out a loan, known as a mortgage, for the remainder of the purchase price.
Like land, home prices tend to increase in value on an average year-over-year basis. It is true that real estate bubbles are usually followed by correctional periods, sometimes causing homes to lose over half of their value. Still, on average, housing prices tend to increase over time, counteracting the effects of inflation.
Impact of deflation on daily lives
Deflation is basically what happens when too many goods are available or when there is not enough money circulating to purchase those goods. What then happens is the price of goods and services drops. While this may seem like a great thing for shoppers, the actual cause of widespread deflation is a long-term drop in demand.
So one of the major downside of deflation could be that it costs you your job. If prices continue to decline, your employer may not be able to remain profitable. To stay in business, there may be layoffs.
If deflation continues long enough, many more people will lose their jobs. As the economy slows, companies go out of business. That’s what happened during the Great Depression. Falling prices sent many firms into bankruptcy.
Deflation often signals an impending recession (two or more quarters during which the economy shrinks). With a recession comes declining wages, job losses, and big hits to most investment portfolios.
As a recession worsens, so does deflation.
Businesses hawk ever-lower prices in desperate attempts to get consumers to buy their products and services.
Deflation is worse than inflation because interest rates can only be lowered to zero. As businesses and people feel less wealthy, they spend less, reducing demand further. Prices drop in response, giving companies less profit.
Once people expect price declines, they delay purchases as long as possible. They know the longer they wait, the lower the price will be. This further decreases demand, causing businesses to slash prices even more. It is a vicious, downward spiral.
Deeper effects of deflation on economy
Deflation can lead to an economic recession or depression, and the central banks usually work to stop deflation as soon as it starts.
When credit providers detect a decrease in prices, they often reduce the amount of credit they offer.
This creates a credit crunch where consumers cannot access loans to purchase big-ticket items, leaving companies with overstocked inventory and causing further deflation.
But this is when a prolonged deflation comes into play. What we will go through next is how as a consumer one can make the most of or take advantage of deflation.
Here are four ways to survive — and even thrive — in a deflationary economy.
- Creating emergency funds
- Grip on finances
- Get out of debt
- Seek opportunities
Creating emergency funds
Most financial experts recommend consumers have a rainy day fund of three to six months of living expenses in cash tucked away for emergencies, such as a sudden job loss.
With unemployment rising, some advisers are raising that target to six to nine months. Switching to a saver’s mind-set may be a challenge for some spenders.
But for many people, the process is under way already. Consumers are being more cautious as a result of the drop in the financial markets and heightened fears of a deep recession.
Tightening your wallet now actually can pay off later. For example, people who spent less during the holiday season are likely to reap the benefits of sales in the start of the new year.
Grip on finances
Getting a firm grip on your financial situation can help ease fears that rear up when headlines turn unrelentingly bleak. An advice that financial planners frequently advise consumers is that – there’s not a lot that we can control, but we can control what we spend.
Most financial experts advise consumers to draw up a budget if they don’t already have one. This reveals where spending is going and helps consumers make adjustments. If you don’t like budgets, there are other ways to get your finances on track.
Save for specific financial goals by setting up automated transfers from your main bank account to a second account. Money in the second account can be earmarked for specific goals, such as college funds for your children, a retirement nest or vacation money.
There are a number of software available out there — a couple being Microsoft Money and Quicken — that can help you track where money goes. These tools tie together your accounts and offer a clear picture of your financial bottom line.
Get out of debt
In a deflationary economy, dollars, or whatever the currency, are worth more going forward. That’s because falling prices allow each currency to buy more in the future. People worried about deflation want to avoid debt because deflation would make paying off a loan even more expensive.
However, while prices in a deflationary economy go down, the amount of your loan does not.
Consumers can take many different steps to lessen their debt burden quickly. If you carry a balance on high-rate credit cards, try to transfer it to a zero-percentage-rate card and pay down the debt as soon as possible.
Ridding yourself of debt can go a long way toward alleviating your financial fears during a deflationary economy.
Seek opportunities: Consumers who have secure jobs, emergency funds set aside and sound financial plans may find that a deflationary economy is a great place to scoop up bargains. Falling prices already are creating opportunities.
People beginning to build an investment portfolio now have a chance to buy stocks of solid companies at bargain prices. Deflation also can offer opportunities to save on smaller purchases.
For example, travelers may find trips offered at big discounts. By investing in assets when prices are low, consumers can use an episode of deflation as a rare opportunity to build wealth, many experts remind.