The Perils of Deflation

Economists and regulators are buzzing again about the perils of low inflation, or perhaps deflation, a topic that has flared up several times in the past couple of years. While fixed-income investors and other consumers may welcome flat or falling prices, the condition can be devastating to borrowers.

The best rule of thumb in a period of deep financial and economic uncertainty: Be especially cautious with long-term commitments. 

The annual inflation rate is around 1%, compared with a long-term average around 3%, and many economists are warning that the U.S. could fall into deflation, a persistent decline in prices across the board. Instead of spurring consumer spending, falling prices during deflation discourage it, as consumers wait for prices to go even lower.

Company revenues and profits then fall, causing employers to lay off workers. The unemployed, or those who worry they might soon be, spend less, perpetuating the downward spiral. As corporate profits fall, stock prices follow.

The most hard-hit in this scenario are borrowers, however, who must continue making payments while their incomes fall and their assets, such as homes, lose value.

At first glance, low or negative inflation might look good for retirees who depend on interest-bearing holdings such as bank savings, which protect principal. But savings yields typically fall during such periods, while the cost of living can rise despite flat or falling prices in the broader economy. Health care, for instance, may continue to become more expensive even in a deflationary period, and an older person may need more of it as time goes on.

Savers can try to minimize the damage by locking in healthy yields while they can. Yields on five-year CDs, for example, average around 1.7%, compared with a mere 0.4% on six-month CDs, according to a BankingMyWay.com survey. The shopping tool shows many banks and credit unions paying between 2.75% and 3% on five-year CDs.

That won’t make you rich, but the guarantee against lost principal would help you sleep at night if the economy did fall into deflation. Once you find a few appealing CDs, get a written description of the terms for each, especially regarding early withdrawal penalties. Typically, a saver with a five-year CD would give up six months of interest earnings for taking money out early. That might be a price worth paying if the economy rebounds and newer CDs are more generous.

Because the odds favor a return to normal inflation some day, most long-term investors should hold stocks, which generally provide more growth than bonds or cash.

Unless you are confident your job is secure and your income will rise, be very cautious about taking on debt. In fact, it would probably pay to reduce existing debt, starting with loans such as credit cards that carry the highest interest rates. Use the Credit Card Payoff Calculator to devise a strategy.

Low home prices and rock-bottom mortgage rates make this look like a good time to buy a home, especially for first-time buyers who wouldn’t have to also sell an existing home in a depressed market. As with other loans, your confidence about future income is key. Obviously, the lower the price of the home, the lower the risk of taking on a loan to pay it, so this probably isn’t a good time to stretch for the most expensive home you think you can afford.

Also think carefully about how long you expect to have the property. If home values stay flat or fall, you could have trouble selling for enough to pay off your loan, a condition faced by many homeowners today. It’s probably unwise in today’s market to buy a home you won’t keep for at least five to seven years.

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

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