How to Prepare for Deflation

If falling prices set in, consumers need to shed debt and conserve cash.

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In the breathless days of the recession, doomsayers warned of runaway inflation thanks to more than $1 trillion worth of new money that the Federal Reserve pumped into the economy. That money is still there, but instead of steep inflation, prices are softening so much that deflation is now a risk. If it happens, Americans could face another economic ordeal that triggers a period of stagnation or even a second bout of recession.

[ See 12 ways to prepare for deflation.]

The rate of inflation over the past 12 months has been a scant 1.1 percent, and prices are getting softer, not firmer. Low inflation is good but it's now below the Fed's target level, and if it slips into deflation it could bring wages down with it and cause a host of other problems. There's good reason deflationary trends could intensify. The air seems to be leaking out of the recovery, with hiring weak, confidence and consumer spending down, housing on life support, government stimulus fading, and the European debt crisis ticking like a time bomb. As demand for many goods weakens, more economists are calling on the Federal Reserve to abandon its usual focus on tamping down inflation and take different steps to combat deflation instead. In recent Congressional testimony, Fed Chairman Ben Bernanke acknowldged that the economy's future is "unusually uncertain" and said the Fed is prepared to act if necessary. But for now, the central bank is sitting tight.

The worry over deflation might seem peculiar. It's usually good news when some prices fall, since consumers get a break and companies are able to become more efficient. But if there's a sustained drop in all prices, as measured by the consumer price index, it can thoroughly destabilize the economy. As prices fall, companies earn less money, so they cut costs to remain profitable. That typically leads to layoffs and pay cuts. Consumers who earn less spend less, and that forces down prices even more. Borrowing dries up, since debt gets more expensive over time when incomes are falling. The resulting credit crunch, combined with depressed spending, can lock the economy into a period of decline that's hard to escape from.

[See 4 reasons to fear deflation.]

Most Americans have never experienced prolonged deflation, since the last time it happened in the United States was in the early 1930s. In Japan, deflation helped produce the "lost decade" from 1991 to 2001, characterized by weak growth and a devastating destruction of wealth that the nation still hasn't recovered from. The Federal Reserve has taken more aggressive action recently than the bumbling Japanese government did in the 1990s, but some economists think deflation will happen anyway, by late this year or next. Even if it doesn't, forecasts now augur a period of very low inflation and painfully weak income growth. Here are some steps consumers can take to prepare for such an austere economy:

Pay off debt. If you owe a lot of money, inflation is your friend. The nominal value of debt is usually fixed the moment it's issued, so it gets less expensive over time if your income and your assets go up by the amount of inflation. That's why young borrowers are encouraged to "stretch" when they buy their first home: Their incomes will most likely rise over time while the mortgage payment won't, so they'll "grow into" the loan. But the opposite is true under deflation: Debt gets more expensive over time, taking a bigger and bigger bite out of your real income. So the less debt you have going into a period of deflation, the better.

[See 4 things financial reform won't do for you.]

Keep cash on hand. Today's puny interest rates on money market and checking accounts are a big turnoff. But with deflation the calculation changes, since even a zero percent interest rate isn't so bad. If real assets are falling in value by 2 or 3 percent per year, then cash is actually appreciating in value compared with other things. Upping your cash cushion also helps prepare for emergencies—or investing opportunities, if they suddenly appear.

Resist the lure of falling prices. Everybody loves a bargain, and the early days of deflation are typically marked by prices that seem too good to be true. But hold your powder. Prices could fall further, and a few months later you might wish you had kept more cash around instead of making impulse buys. Besides, even if deflation doesn't develop, it's unlikely that prices will go rocketing upward with such a weak economy, so if you wait to buy in more stable times you'll still probably get a good deal.

[See 14 things that are getting cheaper.]

Don't spend money before you get it. As inveterate borrowers, Americans are used to spending money before it actually shows up in their bank accounts—by using credit cards, relying on installment plans, or making a big purchase based on a deal that's sure to go through next month. It would be a good habit to break. With deflation, cost-of-living adjustments on fixed-income payments, for example, could be zero or even negative. That's what happened with basic Social Security payments for 2010, because the underlying inflation measure that determines the cost-of-living adjustment was unchanged over the preceding year. Deflation can also wreak havoc with the assumptions and calculations that go into routine credit decisions and everyday dealmaking. So take nothing for granted

Anticipate "no." Most workers feel that they deserve a modest raise from year to year, if only to keep morale from sinking. Sorry, but those days are over. Raises this year are projected to be lower than any other year on record, except for the crisis year of 2009. With millions of excess workers, the downward pressure on wages will probably remain intense for years. And if bona-fide deflation sets in, employers might have no choice but to cut pay and cull their payrolls even more. Instead of asking for a thanks-for-showing-up raise, smart workers should figure out how to enhance their skills, take on more responsibility, and make themselves more valuable; it's easier to argue for a raise when you're contributing more to the bottom line.

[See why raises are so scarce.]

Find a second source of income. If you hit an income ceiling at your job, get another one. Not a new job—where the pay could be even lower—but a second job for a few hours a week that brings in some extra spending money. Professionals might be able to consult or tutor. If you're manic enough to blog every day and good enough to attract readers, you might earn a few bucks from Google ads. Or just sell the clutter in your closets on eBay. Many others have, finding a surprising market for stuff they consider detritus.

Don't "invest" in a home. Just live in it. Americans are slowly making the mental shift away from thinking of a home as an investment, for obvious reasons: Millions of homeowners have lost a fortune as homes have plunged in value. But there are still many buyers on the sidelines, trying to guess when the housing market will hit bottom so they can snap up properties they hope will quickly appreciate in value. That might be foolish. If deflation hits, home prices could drift downward indefinitely. And even if there isn't deflation, it could be years before homes start to rise in value. Thinking of your home as just that—a place where you live—rather than as an investment will lead you to pay for what you need while conserving some cash for other uses.

Be wary of stocks. Stocks go through short-term spurts for all manner of reasons, but on the whole they go up or down in tandem with economic growth. Deflation usually accompanies a recession or slow growth, which suggests that the stock market will be subdued if deflation predictions are correct.

[See how the stock market outran the economy.]

But pay attention to dividends. In a weak economy with a jittery stock market, stocks that pay dividends can be a hedge against potential losses elsewhere. Many companies have slashed dividends over the last several years, but dividends could make a comeback as investors look for safer ways to deploy money. The demand for dividends could even drive some appreciation of the stocks that pay them.

Double down on bonds. With interest rates historically low, many investors find the weak return on high-quality bonds and Treasury securities unappealing. But if deflation occurs, a low return suddenly looks pretty good because it protects principal and offers a bit of appreciation.

Be more productive. The companies that best survive deflation will be those able to sustain sales at lower prices while still making a decent profit. Sorry to perpetuate a tiresome cliché, but that means doing more with less—and doing it gracefully. Individuals can follow the same strategy. Workers able to use technology, help from colleagues, or simple innovations to make themselves more productive will be the workplace standouts, and they'll be the ones with the spare time and purposefulness needed to pull down extracurricular income and keep an eye open for the best opportunities. Note to tech addicts: If you're spending a lot of time sending Tweets or watching YouTube videos, but it's not helping you accomplish more, maybe it's time to ditch the smartphone for a while.

[See 5 reasons a double-dip recession could happen.]

Stay optimistic. Slow growth can feel agonizing and deflation can be punishing, but every day in the tunnel brings us closer to an economic rebound that might actually feel like one. The Federal Reserve has been bold about intervening in the economy, so if deflation does happen, it might be shorter than the worst critics fear. Once it's over, those who have sharpened their skills and conserved cash will be the ones who get ahead. And if you haven't learned by now to prepare for a rainy day, you probably never will.