Now that that the diagnosis of a recession has been confirmed, economists are losing sleep over the odds that we’ll face a bout of deflation.
There are several kinds of deflation that keep global economy doctors up at night. The worst is an across-the-board, body-slam drop in prices of all commodities, economic output, housing, wages and securities last witnessed during the Great Depression.
A less severe form is “stag-deflation,” or stagflation, in which the economy doesn’t grow, yet commodity prices fall. That’s preferable to the ugly 1930s version and may be our present malaise.
A more desirable form of deflation – if such a thing exists – is a decline in commodities prices and savings yields that lasts only for a few months. Economic cheerleaders are hoping for this version, noting that the U.S. Consumer Price Index [fell a record] 1 percent in October. (
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Deflation is encouraging if you have money to spend. Seeing U.S. gasoline prices dip to less than $2 a gallon, and countless holiday bargains from department stores to travel packages, cheers the miser in all of us.
While recessions often feature some form of deflation, it’s too early to tell which type will occur. There’s still a chance that the U.S. government’s multitrillion-dollar borrowing to bail out financial institutions – and possibly automakers – will trigger inflation.
Should you be in the enviable position of having cash and a good credit rating, and are looking to buy property, the deflation news is positive: Deflation generally translates into lower long-term borrowing costs. Depending upon the location, you may be able to find lots of bargains. There’s more than a 10-month supply of homes, and prices are down 17 percent annually on average through September in the top 20 U.S. cities, according to the S&P Case-Shiller Home Price Indices.
If you choose to finance or refinance during this deflationary time, keep in mind that credit standards are much tougher than they were a year ago: Lenders will expect to see consistent proof of income, on-time payments on other accounts and a FICO score well above 700. Request your credit file before you even approach a lender to see if it’s correct. Clear up any mistakes and close any open lines of credit.
You will also need to downsize your expectations for savings yields. When the Fed cuts rates – its benchmark is 1 percent and may go lower – that means paltry returns on certificates of deposit, money market funds and other savings vehicles. While the market for federally insured savings has become more competitive, don’t expect much more than a 4-percent annual yield on a one-year certificate of deposit.
Not all savings instruments lose in a deflationary environment, though. Consider zero-coupon bonds if you have specific cash flow needs by a certain date.
The nasty part of zeros is that, outside of tax-deferred accounts, you are taxed on the interest you would likely receive, even though you don’t pocket it. A municipal bond can alleviate this “phantom” interest catch. Or, just keep them inside a retirement account.
If you try to trade zeros, or hold them within a bond mutual fund, keep in mind that prices are volatile. The only way you are guaranteed the face amount is if you have a solid issuer and you hold them to maturity. But if you want an investment that will allow you to sleep, this is usually a pretty good bet. •
John F. Wasik, co-author of “iMoney,” is a Bloomberg News columnist. 
