[Newsmax] Amidst the current discussions surrounding inflation, another economic phenomenon is quietly gaining momentum beneath the surface. When it eventually comes to light, it is likely to take many by surprise.

This phenomenon is deflation, and despite its positive aspects, such as a decrease in the overall cost of goods and services across the economy, particularly beneficial in times of inflation, it carries inherent risks. The primary risk is the necessity to adapt investment strategies, as approaches effective in inflationary periods may prove ineffective during deflation. Given the lack of widespread understanding of these dynamics, individuals often find themselves financially unprepared.

While the current focus remains on the repercussions of inflation, it is crucial to also acknowledge the presence of deflation and its impact on our financial strategies.

What is Deflation?

While most Americans grasp the concept that inflation leads to increased costs across the economy, it's essential to clarify that inflation signifies a decrease in the purchasing power of the U.S. dollar. However, deflation, its opposite, occurs when costs decline due to an increase in the purchasing power of the US dollar.

Deflation is typically associated with a reduction in the supply of money and credit, but it can also result from heightened productivity, increased supply, and technological advancements. When the Federal Reserve raises interest rates to counter rampant inflation, it triggers a credit contraction, leading to a corresponding decrease in asset values and the prices of goods.

In essence, deflation causes nominal costs of capital, labor, goods, and services to decrease, although it's crucial to note that their relative prices may remain unchanged.

On the surface, this benefits consumers by boosting their purchasing power without requiring an increase in income. While this may seem advantageous, not everyone stands to gain. For instance, deflation can adversely affect borrowers obligated to repay debts in money that is now worth more than the money they initially borrowed, as well as those who invested in assets anticipating rising prices.

What Leads to Deflation?

Both inflation and deflation find their roots in the money supply. Inflation arises when money is injected into the economy, exemplified by instances like the 2008 housing collapse and the 2020 pandemic stimulus. Conversely, deflation results from a contraction in the money supply, a process overseen by the central bank, also known as the Federal Reserve. In essence, when the supply of money and credit diminishes without a corresponding reduction in economic output, costs tend to decline. An excess of goods in the market exerts downward pressure on prices.

It's noteworthy that periods of deflation often follow extended phases of artificial monetary expansion, a trend that has persisted in the United States for quite some time. The last significant deflationary period was witnessed in the 1930s after the Great Depression, while Japan experienced a similar scenario more recently in the 1990s.

How Does Deflation Impact Your Investment Approach?

Similar to inflation, deflation introduces increased volatility to the overall economy, elevating the risk associated with investing. Fortunately, there are measures to safeguard your investments by opting for more stable assets, such as lucrative rental properties, treasury bills, or gold. If you're familiar with my other articles, you likely recognize that real estate consistently tops my list. This preference is rooted in the fact that real estate can generate income regardless of whether the asset's value is increasing or decreasing, serving as a hedge against both inflation and deflation.

It is crucial to meticulously assess a property's current profitability before considering tenant replacement, ensuring it remains financially viable at prevailing market rates in your locality. Additionally, factor in potential repairs in the coming years by obtaining current pricing for these projects, ensuring continued profitability even if repairs become necessary sooner than anticipated. This diligence is always important but becomes significantly more critical in a deflation-driven and volatile economy.

For those burdened with substantial debt, expeditious reduction or elimination of debt, especially variable rate debt, is advisable. As previously mentioned, debt becomes more "expensive" during deflationary periods, imposing a considerable strain on your budget. However, don't shy away from taking on debt during deflation if it is utilized to acquire cashflow-generating assets like real estate.

It's also essential to consider how deflation influences others, as their economic behavior can impact your investments. For instance, if your investments rely on your customer base accessing affordable credit, such as for significant transactions like vehicles, large machinery, or real estate, adjustments to your strategy may be necessary. This is because underwriting guidelines tend to tighten, and interest rates increase during deflationary periods.

In essence, reallocating investments to asset classes that perform well in the face of deflation is crucial. Simultaneously, an understanding of the broader economy is necessary to identify potential downstream effects that could pose additional challenges for your investments.

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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.

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