These days, inflation fears are out. What's in? Concerns about prolonged
, a persistent and general decrease in prices.
While deflation may not sound so bad at first -- in mid-December, gasoline prices were down nearly 60% from July's record highs and holiday discounts abounded -- but it can have serious consequences for the economy and your wallet.
Deflation vs. disinflation:
Deflation differs from disinflation, which is a mere slowing of the rate of increase in prices. That's an important distinction. Disinflation can be good for the market. A study by the Minneapolis-based Leuthold Group found that from 1872 through the last deflation threat in 2002, the
posted a 15.3% gain in years of slight inflation and a 14.6% advance in years of flat to mild deflation.
By contrast, prolonged deflation can turn into a self-fulfilling downward death spiral, as it did during the Great Depression and during the 1990s in Japan, which saw its stock market suffer a long descent during the "lost decade."
How does deflation happen? When times get tough, consumers and businesses cut back on spending, which leads to downward pressure on prices as businesses try to attract customers. Those price cuts squeeze companies' bottom lines. They struggle with costs, debt and payroll; they cut production, and they lay people off. Consumers lose their jobs, or worry about losing them, and they cut back even more. And the cycle spirals on.
Rate cuts and spending:
In October and November, consumer prices fell at the fastest pace since the Labor Department started tracking them in 1947, as the deteriorating economy pulled prices down for oil, consumer goods, homes and stocks. What seems like a boon to consumers, however, has economists and analysts concerned.
No one knows whether we're in for a prolonged deflationary period. Falling prices might just be an adjustment to today's harsh economic conditions. Heavy government spending, interest rate cuts -- like the recent decline in the federal funds rate to a range of zero to 0.25% -- and what many expect to be enormous public works programs under the Obama administration could reverse the trend and accelerate a rebound. (Expect to hear talk of inflation risk when that happens, continuing the cycle.)
What you can do:
You might consider steps to protect yourself from the potential for deflation. Reducing debt is a key starting point. Many Americans are seeing their income suffer, and debt payments will only become more onerous for those who continue to rely on plastic. You also might want to take modest steps to reduce your exposure to investments that would be hit hardest by a prolonged drop in prices, and increase your exposure to those that would benefit.
- Cash and cash investments are good places to be in deflationary times. With prices falling, the money you hold in a money fund or bank account will buy more. High-interest savings accounts and CDs offer protection in these circumstances.
- Stocks suffer in a deflationary environment because companies have to discount their products to sell them. Makers of big-ticket items, such as cars and appliances, take a hit. But some sectors hold up better than others. Consumer staples, health-care products and companies with strong balance sheets perform relatively well in a deflationary environment. People don't stop buying prescription drugs or shampoo during hard times. Analysts are pointing to stocks such as Wal-Mart (WMT) - Get Report and Proctor & Gamble (PG) - Get Report as well as firms that stand to benefit from federal stimulus efforts, such as engineering and construction giant Fluor (FLR) - Get Report.
- Government and municipal bonds can be havens during deflationary periods because their fixed interest-rate payments and relative security become more attractive when prices (and wages) fall. But Treasuries are expensive now. Many analysts are recommending Treasury Inflation Protection Securities (TIPS) for their guaranteed yields.
- Corporate bonds get riskier in deflationary times, and making debt payments becomes more onerous for companies in a tough economy. The risk of bankruptcy tends to grow. That said, yields on corporate bonds are high, and bonds issued by companies with staying power may prove to be bargains.
- Real estate investments can suffer during deflationary periods because their prices fall along with those of other hard assets. That's tough for sellers and those with onerous mortgages -- one reason for the rise in foreclosures. But falling prices can create bargains for those fortunate enough to have cash on hand and a solid credit history. Deflation also means lower long-term borrowing costs. The national average for 30-year mortgages fell from 6.46% to 5.47% before the Fed's Dec. 16 announcement, according to Freddie Mac (FRE) .
Mike Woelflein is a business and personal finance freelance writer. A former senior industry specialist with Standard & Poor's and managing editor of ColoradoBiz magazine, he has also written for The Denver Post and American Express.