How to Prepare for a Deflationary World

Falling prices not widely forecast, but weak growth and government budget cuts have raised the odds.

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With interest rates at zero and forecasts for very low economic growth, fears that the United States could experience falling prices, or deflation, have reappeared.

Experts generally do not expect prices to actually fall, but it's not something they totally disregard. And for retirees, deflation sharply increases the need to find reliable, if modest, investment returns.

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Falling prices may seem to be a consumer bargain. But when prices fall, consumers tend to put off discretionary purchases in anticipation that prices will be even lower in the future. The decline in purchasing eventually hurts corporate profits, wages, and personal incomes. Paying debts with shrinking incomes becomes increasingly difficult, which leads to further spending cuts. And on it goes, in a reinforcing cycle of shrinking economic activity.

Japan suffered an extended period of deflation in the 1990s. Today, the country's economy continues to be bottled up in a low inflation-low growth stagnation that continues to sap its economy.

"We don't expect deflation," says Ryan Sweet, a senior economist at Moody's Analytics. "But even though the odds of deflation are low, you don't want to discount them. If there is a hiccup in growth or another [economic] shock, then the odds of deflation would increase."

Sweet says the extremely aggressive pro-growth policies of the Fed reflect, in part, its desire to prevent falling prices. "You can tell from the Fed that they're worried," Sweet says. "The Fed has a [policy] playbook for dealing with inflation. They don't have a playbook on deflation."

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Housing is a large part of the U.S. economy that's already exhibiting symptoms of a deflationary environment. Home prices have continued to fall even as the economy has recovered. The recession and millions of defaulted mortgages explain much of the problem. But one reason consumer demand for buying homes may be falling is that consumers are holding off purchases because they expect prices to be lower in the future.

Generally, however, consumers are not showing any signs of deflationary purchase behavior, says Scott Hoyt, Moody's senior director of consumer economics. Low rates of inflation are not having an impact on consumer behavior, he says. "I think right now, we're actually in the sweet spot" where inflation is not a big factor in the timing of consumer purchases. Moody's is forecasting weak consumer spending early in 2012 with stronger gains later in the year.

Beyond home prices, U.S. inflation "is still in solidly positive territory" says Alec Young, global equity strategist at Standard & Poor's Capital IQ. Total prices have been rising at 3 percent annual rates and so-called "core inflation," which excludes temporary price increases, is running at a 2 percent annual level.

That's also the long-term inflation target adopted at last week's Federal Reserve meeting. The central bank also said it was extending its commitment to very low interest rates through the end of 2014. Its actions reflected forecasts for an extended period of weak growth. And it's this outlook, along with continued concerns over recessions and debt defaults in Europe, that has raised the odds that deflation might occur.

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"You hear as much fear about inflation as you do deflation," Young says. "But I think the thing that keeps the deflation fear alive" is the record-low yields on longer-term U.S. Treasury bonds, especially the 10-year bond. "The 10-year treasury yield is just uncomfortably low" and should be higher based on other recent investment trends, he says. In Tuesday trading, 10-year treasuries ended the day yielding 1.83 percent.

Even with historically low yields, bonds are still a recommended investment for a deflationary environment. "Even when yields are low, you can get appreciation in bond prices," Young says. Because of concern that a weak economy would hurt corporate profits, prudent investors might want to stick to U.S. government bonds and high-rated municipal bonds.

Dividends are also recommended for an environment of low inflation or deflation. Locking in even a modest income yield of, say, 3 percent, makes sense when real interest rates are negative. "It's not just companies with high yields, but companies with a history of raising them," S&P's Young says. The S&P 500 Dividend Aristocrat Index includes large companies that have raised dividends every year for at least 25 years.

International diversification also can be a sound strategy. Because Europe's economies are closer to experiencing deflation than the United States, Young favors higher-growth emerging markets. "Emerging markets can work well as a deflationary hedge," he says.

Beyond investments, the major imperative of a deflationary economy is to carry as little debt as possible. Falling incomes and prices actually increase the real cost of fixed-price debt. Seniors on fixed incomes could fare well in a deflationary economy if their expenses don't increase. But having a mortgage or other consumer debt makes it hard to balance a budget when prices are falling.

Twitter:@PhilMoeller