Deflation Risk Ahead: But What's So Bad About Falling Prices?

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Most people like to get bargains on the things they buy -- when merchants cut prices, they naturally see it as a win. But among economists, the idea of broadly falling prices is scary -- and the fear of that phenomenon -- aka, deflation -- is on the rise. But even smart investors sometimes wonder what what the big deal is: Why is deflation such a huge threat to the economy?

In his most recent investment outlook, top bond-market investor Bill Gross, who until his recent departure from investment firm PIMCO managed the largest bond fund in the world, said that the possibility of falling prices is back. Comparing the current situation to what Americans saw during the Great Depression and what Japan has experienced in its "lost decades" for its stock market since 1990, Gross notes not only that the potential for deflationary pressure is scaring central bankers, but also that the evolution of the financial system has made it so that "deflation is no longer acceptable."

The Problem With Falling Prices

On its face, deflation sounds like it would be a long-awaited windfall for the general public. After decades of seeing prices on everything you need climb inexorably, deflation would bring those prices down. That would make your savings go further, giving you more purchasing power for every dollar you have in the bank. Especially for those who live on fixed incomes, the prospect of finally getting some relief from the struggles of making ends meet on a limited budget sounds too good to be true.

Yet deflation leads to problems that would eventually adversely affect most ordinary Americans.

First, ongoing declines in prices change the incentives for consumers to buy things. If you expect the prices of the goods you need to go up -- whether we're talking about a new car or your pantry staples -- then you'll seek out bargains and buy those items as soon as you can afford them in order to avoid paying more later. As a result, a bit of inflationary pressure spurs spending and helps support the economy.

If prices start to fall regularly, then that incentive reverses itself. Suddenly, if you're patient, you can save money on your next purchase. Indeed, Americans have seen the impact of deflation in the prices of personal computers, which have declined steadily for decades. Because most people need computers, they can't put off purchases indefinitely. Yet the longer you wait, the better performance you can get, often without paying any more for the newer, higher-quality machines that constantly become available. So we do put off those purchases, and tech manufacturers feel the result.

When deflation becomes more common throughout the economy, the resulting drop in economic activity eventually forces businesses to cut back on their expenses, laying off workers. Those workers have far less income to spend, which leads to layoffs elsewhere, creating a downward spiral that leads to far fewer people in any position to buy those cheaper goods.

The second big problem from deflation is how it affects those who are in debt. As prices fall, so too does the amount of income that employers typically have to pay to provide workers with the same purchasing power and standard of living. Yet monthly payments on outstanding debt remain the same, and so it becomes harder for workers to maintain their debt payments as those payments become a larger percentage of their overall income.

3 Tips to Protect Yourself From Deflation

You can expect central banks to fight deflation with every tool at their disposal. But there are also some things you can do with your own personal finances to reduce the danger of deflation to you and your family.

  • Know that certain investments perform better during deflationary times: Bonds hold their value better, while physical assets like gold and other commodities are liable to get crushed. Stocks tend to deliver mixed results; the best companies to invest in are those that have the market power to maintain their prices even as overall deflation cuts the prices of competing products.

  • Reduce your debt as quickly as possible when deflation strikes. That's true not only for your own personal finances but also for the companies whose shares you own, so make sure to watch closely the debt levels of companies whose stocks you own, and think twice about investing in businesses that use leverage extensively to boost their results.

  • Consider keeping more cash on hand than usual. Cash typically loses purchasing power over time, but during deflation, the reverse becomes true. Moreover, as asset prices get cheaper, you can use excess cash to pick up bargains with the expectation that eventually, central-bank efforts will be successful and inflation will return.

Even with the falling prices that accompany it, deflation really isn't the best thing for ordinary people to experience. With some precautionary measures, though, you can reduce the havoc a deflationary spiral would wreak on your finances.

Motley Fool contributor Dan Caplinger likes lower prices but knows their limits. You can follow him on Twitter @DanCaplinger or on Google+. To read about our favorite high-yielding dividend stocks for any investor, check out our free report.​