New Worries About Deflation
By: Jeff Brown

If there’s a silver lining in the latest minutes of the Federal Reserve’s June meeting, it’s that we don’t have to worry much about inflation.

But deflation is another matter, creating a whole new set of headaches for policy makers, homeowners, consumers and investors. How do you protect yourself from the prospect of falling prices and shrinking paychecks?

Minutes from the Fed’s June 22-23 Open Market Committee meeting said “a few participants cited some risk of deflation,” but also noted others disagreed. However, it was the first time in a year that the possibility of deflation was mentioned at all. Generally, committee members agreed that the economy won’t grow as fast as they had expected earlier. 

Most people are more accustomed to worrying about inflation, when prices rise. Normal inflation levels of around 2% or 3% a year are generally seen as benign. In fact, they can even be good. As your income gradually goes up your mortgage payment gets easier and easier to handle, for instance.

Of course, extreme inflation can be terribly damaging. It makes it less and less likely your retirement savings will cover the ever rising cost of living, for instance.

Certain types of deflation are beneficial, like the gradually falling prices of computers and other electronics equipment. But serious, across-the-board deflation can be as destructive to wealth as rampant inflation.

The best, most current example of that is in the housing market. Millions of people who bought homes in the middle of the decade now find their properties are worth 20% less than the purchase price, and in some formerly soaring markets home prices have fallen by more than half. But the loans taken out to buy these homes are still as big as they were. Experts say about one in four homeowners with a mortgage now owes more than the property is worth.

Deflation also undermines the incentive for businesses and individuals to invest, as they fear the new factory or mutual fund bought today will be worth less a year from now. Of course, lenders are less likely to lend because borrowers with shrinking incomes are less likely to pay their debts. Deflation therefore causes a grinding slowdown in economic activity.

Sophisticated investors can profit on economic decline with techniques like short selling  (borrowing a stock and selling down the road at today’s price and hoping to replace it with shares bought cheaper). But that takes a lot of knowledge and monitoring.

Ordinary stock market investors who go “long,” or buy stocks in hopes prices will rise, can either move to the sidelines with cash or lengthen their time horizons in hopes of waiting out a downturn. Some experts recommend emphasizing stocks in consumer staples companies, as people will continue buying food and medicine while they’ll cut back on luxuries.

Deflation poses serious dilemmas for bond investors. Because deflation typically causes interest rates to fall, the investor may want to lock in higher rates before deflation gathers steam. Not only will that assure a higher income from interest earnings, the bonds could gain value as prevailing rates fall, making the older, more generous bonds more attractive to investors.

But as the economy slows bond issuers may have a harder time coming up with the money they owe their investors, increasing the risk of default, which undermines bond values. Corporate bonds can be hit especially hard.

Many fixed-income investors therefore turn to U.S. Treasury bonds viewed as comparatively safe because they are backed by the government’s taxing authority. Short-term bonds are the safest, as their prices hold up better when interest rates fall. Federally insured bank savings such as certificates of deposit are a safe way to preserve cash in deflation, though interest earnings are minimal.

How serious is the deflation risk today? Economists and officials at the Federal Reserve are divided on that point, though many agree economic growth will be slower than earlier expected, and that the high unemployment rate is unlikely to substantially improve very soon.

For now, deflation is just a possibility, not a sure thing. But if deflation worries you, it’s probably not a good time to take on a lot of debt. The asset you buy, such as a home, could lose value and your income could fall.

 

—For more ways to save, spend, invest and borrow, visit MainStreet.com.

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