The economic doldrums currently afflicting the country have the potential to spiral into deflation. That's not just the opinion of fiscal doomsayers, but some heavyweights as well.In a research paper released at the end of July, James Bullard, president of the Federal Reserve Bank of St. Louis, stated that the U.S. faces the risk of deflation. Coming from a voting member of the Federal Reserve's Federal Open Market Committee, this statement crystallized the threat into a real possibility -- if only one of several."Deflation over any period of time is still an unlikely scenario, but it's still a possible scenario," says Bankrate's senior financial analyst Greg McBride, CFA.
Deflation is now a concern thanks to the events of previous years."The driver behind this deflation (is) a collapsing credit bubble. Debt and credit is collapsing faster than the government can re-inflate, which is what causes cash to increase in value relative to assets," says Todd Tresidder, founder of FinancialMentor.com.Recent months have seen a slowdown in economic growth, which, combined with the stubbornly high unemployment rate and a slowdown in consumer spending, make for "trends that are more conducive to prices falling further and not moving up," says McBride."Prices are still increasing but at a snail's pace, with people saving more and paying down debt. There is less spending and very high unemployment -- the ingredients could be there for prices to start to fall on a sustainable basis," he says.
Time to panic?
The good news is that deflation is not the most likely outcome of the current economic environment.That deflation worries are hanging over the economy at all is the bad news."When an economy experiences deflation, the purchasing strength of its monetary unit, the dollar in our case, increases, meaning the prices of all goods -- including labor -- experience downward pressure," says Albert Lu, principal at The Woodlands Bullion Company in The Woodlands, Texas.Falling prices and dollars that buy more sound promising to the consumer. But, "if people feel prices will be cheaper tomorrow, they won't spend money today. That is how it can lead to a downward spiral in the economy," says McBride.
What can you do?
Failing companies and rising unemployment would negatively impact investors in almost all asset classes. If, indeed, deflation is at the country's doorstep, investment advisers recommend a strategy of capital preservation and income generation.That means stocking up on very safe investments."We would forgo equity gains and rather produce income through high-grade corporate bonds, U.S. Treasury bonds and notes, bank CDs and even dividend-paying stocks of strong companies," says Mark Stys, chief investment officer of Bluemont Capital Advisors in Great Falls, Va.Even keeping part of your portfolio in cash can be a smart move if deflation truly is a problem."In the past you didn't want to keep cash because it loses 3 percent purchasing power per year (due to inflation)," says Wayne Copelin, Certified Financial Planner and president of Copelin Financial Advisors in Sugar Land, Texas. "But if we move toward a deflationary environment, cash isn't losing purchasing power. In fact, it's gaining purchasing power just sitting in a cigar box under your bed."But don't overhaul your investment portfolio on just the possibility of deflation, says Bankrate's McBride."A well-diversified portfolio will, by virtue of being diversified, have some protection against a deflationary environment -- such as cash and high-quality government and corporate bonds," he says.For consumers, a tanking stock market is bad enough, but it's not the only danger lurking in deflation.Debt becomes more expensive.Paying down costly credit card debt is never a bad idea, but in a deflationary environment, debt will be even more of an anchor on a household's finances."You will pay off your debt in the future with dollars that are worth more than they are today. So paying off your debt is extremely important," says Mickey Cargile, founder and managing partner of WNB Private Client Services and Cargile Investments.In an inflationary period, workers get more dollars to pay off stable debts. However, in a deflationary economy, the opposite is true."In an environment where deflation persists for any period of time, your debts become more onerous. Your income is dropping but the $500 car payment is still a $500 car payment," says McBride.If you're not already budgeting your income, then there's no time like the present to get started. Funnel as much extra income as possible into debt repayment and an emergency savings account.While no one can control the economy or even predict that they'll be gainfully employed one year from now, paying down debt and building substantial cash reserves can help mitigate the impact of any unforeseen financial shocks.Plus, you'll be in a better position to profit when the economy improves. But improvement won't happen without a little more struggle."We're deleveraging the country. And that is going to bring down growth rates. It's simple math. It's something that is good; we're paying the price for the leverage that we have put on for the past 20 years," says Cargile."It's not a quick fix, but ultimately we will emerge with a stronger economy," he says.