What is deflation? A general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression

What has the Federal Reserve done? Declining prices, if they persist, generally create a vicious spiral of negatives such as falling profits,  closing factories, shrinking employment and incomes, and increasing defaults on loans by companies and individuals. To counter deflation, the Federal Reserve (the Fed) can use monetary policy to increase the money supply and deliberately induce rising prices, causing inflation. Rising prices provide an essential lubricant for any sustained recovery because businesses increase profits and take some of the depressive pressures off wages and debtors of every kind.

1. The Federal Reserve has lowered the Federal Funds Rate to 0% flooding the economy with liquidity.
2. The Fed is buying Fannie Mae and Freddie Mac debt to lower mortgage rates.
3. The Fed is buying 10 and 30 year Treasuries to lower the long-term cost of borrowing.
4. The Treasury is recapitalizing banks so they are not insolvent and will resume lending to the public.   

This is normally very inflationary, but in a deflation, that is exactly the point.  Deflation is just negative inflation, so the best way to stop negative inflation is to create inflation.  

 

How should you invest?

1. In a deflation, the real value of debt increases since lenders are being repaid with money that is more valuable than the money that was lent out.  Periods of deflation are the wrong time to take out huge loans and debts.

2. If you are going to buy bonds, buy Treasury Inflation Protected Securities over Nominal Bonds.  TIPS return the real interest rate, which is higher than the nominal interest rate in periods of deflation.  Also, if after the deflation ends, and there is large increases in inflation from the actions of the policies of the Federal Reserve, the TIPS will protect you from increases in expected inflation.  
3. Buy Real Estate, but only in scenarios where the cash flows or rents from the property cover your cost of owning the property (rents, insurance, property tax).  There are significant opportunities in this market where these properties exist.