Inflation has been a stressful reality for many Americans recently, having a marked impact on consumer budgets. But with inflation rates finally slowing, and the threat of a recession in the news, deflation is also a phenomenon many should prepare for.
Deflation, or a decline in prices of goods and services across the economy, might seem like good news after dealing with high prices for so long. However, the trend is typically accompanied by job loss, poor investment return and other side effects.
The good news is this: Preparing your finances for deflation involves many of the same good financial habits as preparing for inflation does. Those financial moves include shoring up your emergency savings and carefully choosing investments.
What Is Deflation and Why Is It a Risk to Your Finances?
“Deflation is when the general prices of goods and services start to fall and typically a sign of an economy that is weakening,” says Andrea Woroch, consumer and money-saving expert and U.S. News contributor.
At the moment, however, the U.S. is still experiencing inflation, albeit at a rate that has shrunk from recent highs.
Historically, deflation is triggered by a recession and low consumer spending, says Tom Graff, head of investments at Facet. So despite the fact that Americans may be a ways off from deflation, the threat of an impending recession has many worried about the phenomenon.
Deflation is a sign of a poor economy, but it has both negative and positive effects on the average individual.
“It can be good because it gives people more purchasing power, which can stimulate the economy. However, companies and businesses will have to reduce production to offset loss in profits which can be followed by layoffs and liquidations,” Woroch says.
Graff adds that the value of your assets is likely to decline and your income could go down.
How to Prepare for Deflation
Americans can take several steps to prepare for deflation, even if it isn’t currently an economic reality. Consider these steps:
— Build emergency savings.
— Consolidate debt.
— Be careful about investments.
Here’s more information on each step.
Build Emergency Savings
An emergency fund is a critical tool for getting through many financial storms. With a healthy amount of emergency savings, you’ll have a safety net if your income stops growing or you lose your job.
“Deflation usually results in households having less income, or at least that people stop getting raises. That could be exactly the time you want to have a little extra money socked away to handle expenses,” Graff says.
It’s worth consolidating and repaying debt before deflation hits.
Deflation “can harm borrowers who end up paying their debts in money that is worth more than when they borrowed it. It’s like borrowing a cup of sugar from your neighbor, but when you return it, you have to give back a cup and a half,” says James Allen, founder of Billpin.com.
Plus, interest rates tend to rise during a recession.
Consolidating debt now may take away this stress in the future. Woroch recommends looking into balance transfer credit cards while there are still good offers on the market.
“Transfer your credit card debt to a 0% balance transfer card, which will waive interest fees on the balance for anywhere from 12 to 21 months, depending on the card offer, helping you save a lot in interest. This way you get out of debt faster and can put more of your money toward savings and retirement,” she says.
Be Careful About Investments
Deflation and recession can limit the growth of your investments. If you’re worried about deflation, take the time to discuss your investment portfolio with a financial advisor and make adjustments according to the different risk levels.
For instance, Graff recommends being cautious about real estate investments.
“Don’t buy a house assuming the price will go up. It is often said that your home is your biggest investment, but we don’t think you should think of it in those terms,” he says. “If you finance your home in such a way that it needs to appreciate for the purchase to make sense financially, you are leaving yourself vulnerable. This is true whether the whole economy suffers a bout of deflation or merely your local housing market turns weaker.”
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Update 07/14/23: This story was published at an earlier date and has been updated with new information.