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Deflation: Is it real? What can you do?

Highlights
  • A collapsing credit bubble is raising the specter of deflation.
  • With deflation, the prices of all goods, including labor, fall.
  • What to do: eliminate debt, save money and diversify portfolio.

The economic doldrums currently afflicting the country have the potential to spiral into deflation. That's not just the opinion of fiscal doomsayers, but some heavyweights as well.

In a research paper released at the end of July, James Bullard, president of the Federal Reserve Bank of St. Louis, stated that the U.S. faces the risk of deflation. Coming from a voting member of the Federal Reserve's Federal Open Market Committee, this statement crystallized the threat into a real possibility -- if only one of several.

"Deflation over any period of time is still an unlikely scenario, but it's still a possible scenario," says Bankrate's senior financial analyst Greg McBride, CFA.

Why deflation?

Deflation is now a concern thanks to the events of previous years.

"The driver behind this deflation (is) a collapsing credit bubble. Debt and credit is collapsing faster than the government can re-inflate, which is what causes cash to increase in value relative to assets," says Todd Tresidder, founder of FinancialMentor.com.

Recent months have seen a slowdown in economic growth, which, combined with the stubbornly high unemployment rate and a slowdown in consumer spending, make for "trends that are more conducive to prices falling further and not moving up," says McBride.

"Prices are still increasing but at a snail's pace, with people saving more and paying down debt. There is less spending and very high unemployment -- the ingredients could be there for prices to start to fall on a sustainable basis," he says.

Time to panic?

The good news is that deflation is not the most likely outcome of the current economic environment.

That deflation worries are hanging over the economy at all is the bad news.

"When an economy experiences deflation, the purchasing strength of its monetary unit, the dollar in our case, increases, meaning the prices of all goods -- including labor -- experience downward pressure," says Albert Lu, principal at The Woodlands Bullion Company in The Woodlands, Texas.

Falling prices and dollars that buy more sound promising to the consumer. But, "if people feel prices will be cheaper tomorrow, they won't spend money today. That is how it can lead to a downward spiral in the economy," says McBride.

What can you do?

Failing companies and rising unemployment would negatively impact investors in almost all asset classes. If, indeed, deflation is at the country's doorstep, investment advisers recommend a strategy of capital preservation and income generation.

That means stocking up on very safe investments.

"We would forgo equity gains and rather produce income through high-grade corporate bonds, U.S. Treasury bonds and notes, bank CDs and even dividend-paying stocks of strong companies," says Mark Stys, chief investment officer of Bluemont Capital Advisors in Great Falls, Va.

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Even keeping part of your portfolio in cash can be a smart move if deflation truly is a problem.

"In the past you didn't want to keep cash because it loses 3 percent purchasing power per year (due to inflation)," says Wayne Copelin, Certified Financial Planner and president of Copelin Financial Advisors in Sugar Land, Texas. "But if we move toward a deflationary environment, cash isn't losing purchasing power. In fact, it's gaining purchasing power just sitting in a cigar box under your bed."

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