At first glance, the most recent inflation data looks like terrific news: Inflation is running at its lowest level in 44 years. Consumer prices actually fell in April by 0.1 percent, mainly because of a drop in energy prices. With food and energy excluded – because they’re so volatile they distort the picture – the remaining “core” index of inflation grew just 0.9 percent over the previous year.
So, hurray! Right?
Well, not so fast. Economists, who look every gift horse in the mouth, are muttering about the perils of deflation, which is when prices fall. Not many think deflation is very likely, but most agree it would be a bad thing.
What’s the problem? Aren’t lower prices good for consumers? Aren’t they especially good for older consumer with fixed incomes?
Most consumers welcome falling prices for computers and big-screen TVs, and we’d all love to see medical costs go down. But persistent, across-the-board deflation can wreak havoc on an economy.
The biggest losers are people with debts, especially long-term debts like mortgages, because payments stay the same even if deflation drives down incomes and asset values.
We’ve had a big dose of that in the past couple of years. Housing prices have fallen but homeowners’ mortgage obligations haven’t. Now, an estimated 15 million homeowners owe more than their properties are worth. A homeowner who cannot sell the home for enough to cover the mortgage balance is trapped, perhaps unable to move for a better job.
When prices of products and services fall, companies that sell them earn less. Falling earnings can therefore cause stock prices to fall. Corporate bonds can lose value as well, because investors worry that falling sales will make it harder for companies to make the bond payments they’ve promised.
Of course, falling revenue can also force companies to lay off workers. With fewer people working, tax revenue shrinks and government may have to cut services.
As I said, not many economists think deflation is a sure thing. Still, it does pay to keep all possibilities in mind when you set your long-term financial strategy.
To protect against deflation, avoid piling up debt. I wouldn’t say don’t buy a house. But I’d suggest buying the least expensive house that satisfies your needs, not the most expensive one you can afford.
Federally insured bank savings and U.S. Treasury securities offer good protection against deflation, because you can be confident the government will do everything it can to protect your principal and continue paying interest.
Again, I wouldn’t go overboard and exchange all my stocks for cash. But a hint of deflationary possibilities is just another reason to make sure you have a healthy rainy-day fund and a sensible asset allocation – an appropriate mix of stocks, bonds and cash for your age and risk tolerance. Incidentally, dividend-paying stocks tend to do better in deflationary periods than stocks that don’t pay dividends. That’s because dividends can be put into safe cash holdings.
Over the long term, inflation is more likely to be a factor in your financial life than deflation. Having inflation of only about 1 percent for the past year means you’re a little ahead of the game, since inflation tends to average about 3 percent a year.
Stocks can be hurt when inflation spikes, because companies have to pay more for labor, supplies and raw materials. But companies respond by raising prices for the goods and services they sell.
Over the long term stocks are a pretty good hedge against inflation. In the 20th Century, stocks returned around 10 percent a year, about 7 percentage points above the average inflation rate. With bonds, you’re lucky to earn 2 or three percentage points above inflation, while cash like bank savings typically earns nothing once inflation is taken into account.
So, bottom line: We should be happy about the latest low-inflation figures and not worry too much about deflation. But it’s wise to remember that either force can do a lot of damage.
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