investing

Afraid of deflation? Here's what to do

Highlights
  • A steep decline in prices may seem like a consumers' paradise at first.
  • Most deflation scares have thankfully turned out to be false alarms.
  • Some stocks are more vulnerable to deflation than others.

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.

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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.

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