Yahoo Finance 4 Ways Deflation Can Hurt Your Finances – And How To Prepare for It
Everyone’s heard about inflation and how everything’s becoming unaffordable — but few are aware of “deflation” and its equally negative impact on our finances.
According to experts, deflation — defined as a general decline in prices for goods and services — can have significant and often detrimental effects on the economy and our individual finances.
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“Unlike inflation, which erodes purchasing power, deflation increases the real value of money but can lead to reduced consumer spending, lower business profits, and increased unemployment,” said Dennis Shirshikov, head of growth at GoSummer and finance professor at the City University of New York.
Below are some ways this can be bad for your pocketbook, and some ways you can prepare for it.
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Higher Unemployment
One of deflation’s most severe impacts is higher unemployment. As prices fall, businesses earn less revenue, leading to cost-cutting measures like layoffs or hiring freezes.
“For example, during the Great Depression, deflationary pressures led to widespread unemployment, creating a vicious cycle of reduced income and spending,” Shirshikov said. “In today’s context, a similar scenario could see businesses across various sectors scaling back operations, resulting in significant job losses.”
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Melanie Musson, finance expert with Clearsurance, agreed that unemployment is a huge side effect.
“Deflation means the economy is not growing, and as a result, there will be widespread unemployment,” Musson said. “In the current environment, there are jobs available. Whether an unemployed person wants to take the jobs available is their choice. In deflation, there won’t be options.”
Decrease in Demand
According to Shirshikov, deflation also leads to a decrease in demand for goods and services, further reducing economic activity and exacerbating deflationary pressures.
“When consumers expect prices to continue falling, they may delay purchases, anticipating better deals in the future,” Shirshikov said. “For instance, if consumers hold off on buying big-ticket items like cars or homes, the industries producing these goods suffer, leading to a broader economic slowdown.”
Reduction in Economic Activity
Overall, experts note deflation often leads to reductions in economic activity.
“Lower consumer spending translates to lower business revenues, prompting companies to reduce production, which in turn leads to layoffs and further decreases in consumer spending,” Shirshikov said.
This cycle is particularly damaging to economies heavily reliant on consumer spending.
Assets Lose Value
“With deflation, your assets will lose value,” Musson said. “But you won’t be able to sell your house unless you’re ready to absorb that loss.”
So, for example, she said if you bought a house for $500,000, deflation could bring the value to $400,000, leaving you stuck with a higher mortgage payment.
Diversify Investments
Diversifying investments helps protect your assets during deflationary periods.
“Holding a mix of asset classes, such as stocks, bonds, real estate, and precious metals, can mitigate risks,” Shirshikov said.
For example, while stocks might suffer, bonds, particularly government bonds, tend to perform well in deflationary environments due to their fixed-income nature.
Justin Godur, finance advisor and founder of Capital Max, equally advised the importance of maintaining a diversified portfolio.
“To combat these effects, it’s crucial to take proactive steps,” Godur said. “First, maintaining a diversified investment portfolio can help mitigate risks associated with deflation.”
He added that investments in assets that traditionally perform well during deflationary periods, like government bonds, provide a buffer.
Increase Cash Reserves With An Emergency Fund
“Building up cash reserves can provide a cushion during deflation,” Shirshikov added.
Cash holds its value better during deflation, he explained, and a substantial emergency fund helps cover expenses during periods of unemployment or reduced income. Godur agreed, citing it as a vital strategy.
“Having readily accessible cash ensures you can weather periods of economic instability without resorting to high-interest loans or credit,” he said.
Pay Down Debt
Deflation increases the real value of debt, making it more expensive to repay over time. Shirshikov said prioritizing debt repayment reduces financial strain.
“For instance, focusing on high-interest debt first can provide immediate financial relief and reduce the overall burden,” Shirshikov said.
Focus on Essential Purchases
During deflationary periods, it’s wise to prioritize essential purchases and delay non-essential spending.
“This strategy helps preserve cash and ensures that resources are available for critical needs,” Shirshikov said.
Strengthen Skills and Education
Investing in skills and education can enhance job security and employability.
“In deflationary environments, where job competition is fierce, having advanced skills or additional qualifications can make a significant difference,” Shirshikov explained.
Godur similarly agreed that focusing on enhancing your skills and education can make you more valuable in the job market, thereby reducing the risk of unemployment.
“In essence, while deflation poses significant challenges, understanding its mechanisms and preparing accordingly can safeguard your financial well-being.”
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This article originally appeared on GOBankingRates.com: 4 Ways Deflation Can Hurt Your Finances – And How To Prepare for It
