Afraid of deflation? Here's what to do

In terms of economic threats, deflation has historically been low on the list for most Americans. After the scourge of inflation produced economic havoc in the 1970s and 1980s, most of the country breathed a sigh of relief when monetary policies under Fed leaders Paul Volcker and Alan Greenspan, respectively, brought the destructive upward spiral of prices under control.

While it is now all but impossible to detect inflation, some analysts are getting shortness of breath over a new fear: deflation. Although it is rare, deflation is potentially just as virulent as inflation. Here are some steps to consider taking to protect yourself -- and your assets -- should a deflationary cycle occur.

Deflation defined

First, some definitions: Deflation is, in simplest terms, a decline in prices. Isolated deflation occurs all the time. Sometimes it's beneficial -- such as when oil gluts produce lower gasoline prices. And sometimes it hurts, like when housing bubbles pop.

But the kind of deflation that concerns economists involves a prolonged and steep decline in prices across the board. It may sound like a consumer's paradise, at least at first. However, the long-term impacts of deflation are indeed worrisome. Corporations see their profits shrink, workers might be pressured into wage cuts or layoffs, and economic activity crumples as consumers delay spending for the inevitably lower prices of tomorrow.

Keep in mind that most deflation scares have thankfully, turned out to be false alarms. There were deflation fears after the 1987 stock market crash, just as there were after the tech bubble popped about a decade ago. Currently, there is every reason to believe that the U.S. economy can stave off deflation should the recovery gain steam.

And of course, deflation is a matter of degree. By comparison, the U.S. had problems with inflation before, but not the hyperinflation that crippled Latin America back in the 1980s. Similarly, current U.S. deflation, if it's there, is relatively mild, unlike the debilitating deflation behind the 20-year economic quagmire in Japan.

What's clear is that deflation, like any economic phenomenon, produces winners and losers. Here are some strategies worth considering in both scenarios.

The losing strategies

Big purchases paid with long-term loans are unwise in a deflationary environment. We already know from the recent recession that home prices can fall. Deflation would, in all likelihood, take them lower.

That means you would be making payments -- for 15 or 30 years -- on a depreciating asset. Yes, you have to live somewhere. But large, long-term debt commitments are a bad idea during deflation. You're paying back dollars that are more valuable than the ones you borrowed.

Some stocks are more vulnerable to deflation than others. Companies sitting on piles of cash could actually benefit, but highly leveraged companies involved in things like commodity production are vulnerable. Similarly, consumer goods makers -- especially those in nonessential luxury products -- are likely to lose their power to raise prices. Declining sales and profits would obviously put downward pressure on share prices.

What about winners?

For starters, winning strategies include investments that pay you fixed income over the long term. Some examples are high-quality corporate bonds and municipal bonds. The default risks are going to be relatively low, particularly if you invest in them through bond funds, which will have a diversified portfolio of holdings.

Another thought is the plain-vanilla FDIC-insured certificates of deposit. Yes, the returns might seem low. But look behind the numbers to get the real rate of return: If prices are deflating 2 percent annually, a 2 percent CD is actually paying 4 percent. If you think deflation will last, lengthen your maturities.

Are there still risks? Obviously. With corporate bonds, if deflation begins taking the economy down, default risks rise. With CDs, you could miss an opportunity if you are stuck in a low-yield holding pattern when inflation returns, an event that would likely usher in higher interest rates.

As always, Treasurys are about as low a risk as you can get. Some even point to Treasury Inflation-Protected Securities, which periodically adjust the principal to account for inflation, as a deflation hedge. According to the U.S. Treasury Department, if deflation occurs, the principal on your TIPS is adjusted downward, which means you will get paid less interest while you hold it. However, if at maturity the adjusted principal is less than the original value, you get the original amount.

One final thought: Just keeping your portfolio in cash isn't the worst idea. Deflation is a case of dollars rising in value. Having cash can help you weather the storm. It means you aren't spending it on something that will cost less tomorrow, and you will have capital to deploy once you think prices have hit bottom.


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