How Deflation Affects Your Money

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Dave Carpenter, AP Personal Finance Writer

CHICAGO (AP) — Deflation is the potential new boogeyman for consumers, replacing inflation.

Absent in any significant way since the Great Depression, deflation — a prolonged period of downward-spiraling prices of goods and services — is seen as a possible threat after three straight months of falling prices.

Lower prices might sound appealing, making the cost of everything from cars to food to vacations cheaper. But prices decline because of a lasting drop in demand, which also means employers lower wages and consumers slow spending. It's a combination that can drag down an economy for years.

The fear is going the way of Japan, which has battled periods of deflation for two decades. The country still hasn't recovered from its "Lost Decade" of the 1990s, when bubbles in the stock and real estate markets burst and the economy fell into years of recession and stagnation.

The danger doesn't appear imminent. The Federal Reserve has signaled it's ready to take the necessary steps to prevent anything similar occurring here. And the chances of deflation receded somewhat with the disclosure that the consumer price index edged up 0.3 percent in July.

Still, the slight rise hasn't erased the issue because concerns remain about a double-dip recession.

Consumers wondering what it would be like need look no further than the housing market, which has been in steep deflation for four years. "It's much easier to tame inflation than it is to derail deflation once it gets started," says Diane Swonk, chief economist at Mesirow Financial Inc., a Chicago-based financial services firm.

Over the next three to five years, she says, it's a greater risk than inflation.

Here are some points for consumers and investors to keep in mind if deflation occurs:

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1. Reduce your debt.

One of the best ways to prepare for deflation is to focus on paying off debts. In a period of widespread price declines, your wages may fall and it gets tougher to pay off credit cards, auto loans, student loans and mortgages.

"For most people, the best way to get a good return on investment is to pay down whatever debt they have," says Jerry Webman, senior investment officer at OppenheimerFunds Inc.
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2. Buy high-quality bonds.

U.S. Treasurys, and to a lesser extent high-quality municipal and corporate bonds, are the best defense against deflation. Bond prices rise as interest rates fall.

Treasurys also are a particularly welcome refuge because of the safety factor, because bankruptcies rise in deflationary periods as companies go under in the tougher economic conditions.

Relying too heavily on bonds carries its own risks, however, so don't lock up the bulk of your holdings in Treasurys. It is possible to lose money in bonds.

"If we see inflation with long-duration, that will be a painful part of your portfolio," says Webman. "Getting 2.6 percent on 10-year Treasurys will have proven a bad investment."
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3. Don't load up on stocks.

The stock market fares poorly under deflation.

Companies are pressured by falling prices and cannot keep up revenues or profit margins, driving investors away. And investors have less to put into the market.

That makes it a better time to have your money in cash. But not all of it. Most experts agree that it's necessary to keep a significant amount of your money invested in stocks in order to ensure the best returns over a long period.

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4. Keep an eye on these sectors.

Some sectors and stocks may provide protection against deflation.

Companies with strong brands, an international presence, below-average debt and lots of cash are the safest bets because they should be the best-positioned to withstand an extended economic slowdown.

Using what happened in Japan as a gauge, investors should avoid food and beverage makers, household product manufacturers, as well as mining and other materials companies, according to Sam Stovall, chief investment strategist at Standard & Poor's. They would want to embrace energy and financial stocks and keep an eye on health care and technology.

Stovall recommended the following companies as good investments during deflation: drugstore operator CVS Caremark Corp. (Stock Quote: CVS), retailer Walmart Stores Inc. (Stock Quote: WMT), oilfield services company Schlumberger Ltd. (Stock Quote: SLB), credit card company Discover Financial Services LLC (Stock Quote: DFS), bank JPMorgan Chase & Co. (Stock Quote: JPM), drug distributor McKesson Corp. (Stock Quote: MCK), package deliverer FedEx Corp. (Stock Quote: FDX), defense contractor ITT Corp. (Stock Quote: ITT) and Korean steelmaker POSCO LLC (Stock Quote: PKX).
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5. Don't lose sleep over the risk.

Deflation can be difficult for people, and whole economies, to endure. But we're not there yet, and most economists think the chances are below 50-50.

"Our expectation is that the U.S. will skirt deflation, but that the low saving rates in the U.S., still-growing populations, and quick and decisive Federal Reserve moves to expand the money supply can avoid the trap," Standard & Poor's said in a report last week.

Unemployment and debt pose more immediate problems for the economy.

"I would tell people to calm down about it," says Webman of OppenheimerFunds. "It's not the greatest risk we're facing right now."

Copyright 2010 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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