The Perils of Deflation

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.