Why Are Inflation and Deflation Important?

As Americans struggle through what we hope is the tail end of the “Great Recession”, we hear the terms “inflation” and “deflation” often.  For many people, these terms mean little beyond the definitions of “a rise in general prices” and “a fall in general prices”, respectively.  In many ways however, inflation and deflation are two of the biggest drivers for your investment decisions. How, then, does inflation and deflation really affect our families and finances?

Inflation

If you recently noticed retail prices have increased, you can blame inflation.  Our money does not buy the same amounts of goods and services as before.  However, this is not entirely negative, because inflation allows businesses to offer more employment opportunities.  In fact, many economists believe a gradual and stable inflation rate of 2 to 3% per year is a positive factor in maintaining a low unemployment rate, a stable amount of consumer spending, and desirable lending and savings rates.  Right now, for example, the hope in inflating prices is that companies may begin to hire employees and reduce the unemployment rate.  However, this only works if consumers continue to spend and invest. 

Deflation

On the other hand, prices that decrease can produce deflation, which, when left un-countered, can spiral out of control.  As consumers, we would think deflation would be a good thing because we can buy more with our money.  However, deflation often traps people into cutting off spending until prices reach rock bottom.  A slow-down in spending then causes businesses to slow production and to decrease their own spending, including laying off and/or firing employees.  This cycle continues until the scales are balanced again and consumers have faith in the government and businesses.    

Inflation and Deflation in Today’s Economy

If inflation is desirable and deflation is not, how do we control the level of inflation in America?  The magic number of desired inflation is 2 to 3%, and the United States can control the level of inflation by printing additional money, decreasing prime lending rates, and piping money into the economy. 

Let’s look at the recent housing bust as an example.  To counter the 2007 housing market crash, in 2008 the government tried to stimulate the economy by flooding consumers with extra money. If this sounds dangerous, it can be. The Federal Reserve lowered interest rates to try to get more banks lending and more consumers buying. Unfortunately the results were limited. While we can never know what would have happened had the government not stepped in, most people can agree the results were still very painful.

Inflation and deflation are difficult to control, but as we continue to struggle out of our Great Recession, we aim for a slow, stable increase to our desired 2 to 3% inflation rate. 

Why Do I Care?

The reason you as an investor want to pay attention to these numbers is so that you can make good investments. More than a simple question of how much goods will cost in the future, inflation tells you what kind of returns your investments need just to break even.

If inflation is 3% and my money is tucked away in my mattress, it's losing value -- everything costs 3% more. This is why it's so important to look for investments that return more than inflation; your regular old bank savings account -- unless it's returning more than 3%, the rate of inflation -- may actually be losing you money.

Aim for investments that will return more than the rate of inflation.

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