U.S. Next to Witness Long Period of Deflation?

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While there’s a significant amount of talk among investors about inflation being ahead in the U.S. economy, the indicators are, against all odds, currently showing the complete opposite.

The Consumer Price Index (CPI), the most quoted indicator of inflation, declined 0.4% in April, continuing its slide from the previous month, when it decreased 0.2%. (Source: Bureau of Labor Statistics web site, last accessed May 22, 2013.) So far, from January through April, inflation in the U.S. economy has increased only 0.1%.

Looking at other indicators of inflation—such as the Producer Price Index (PPI), considered to be an early indicator of inflation—these indicators suggest the same and show a steep decline. The PPI registered a decline of 0.7% in April, after declining 0.6% in March. (Source: Ibid.) The index has turned negative from the beginning of the year.

Going by all this, can the U.S. economy go through a period of deflation, when prices decline?

To say the very least, looking at inflation data from the last two months (March and April), it is still too early to say if the U.S. economy will experience a period of deflation—but it shouldn’t be ruled out.

Consider the Japanese economy: it has been experiencing deflation for more than a decade, despite the efforts taken by the Bank of Japan to jumpstart the economy. Similar to what the Federal Reserve is doing now in the U.S., the Bank of Japan has kept interest rates artificially low and has taken more aggressive steps to bring in inflation; however, it continues to fail.

Considering deflation as one of the possible scenarios in the U.S. economy, what should an investor do?

Again, deflation is when prices go down; this means that an individual’s buying power actually increases. During periods of deflation, cash is king. Investors should focus on paying off their debt as quickly as possible, because it appreciates in value as well.

Another step investors can take is to consider buying into well-established and stable dividend-paying stocks; note the focus is on stability. In times when prices are declining, the price of stocks actually goes down. Buying into stable dividend-paying stocks keeps the downside risks on a portfolio to a minimum and provides investors with streams of cash flow.

During a deflationary period, speculative stocks are not the place to be, because as the prices decline, eventually companies have to sell for less than what they produced for. This results in deep losses for firms that rely on very few products.

I don’t see deflation to be a problem in the U.S. economy because the inflationary pressures are continuously building up: we have interest rates that are too low, the Federal Reserve is still injecting $85.0 billion a month into the U.S. economy, and economic conditions seem to be getting better—all different from the Japanese economy.

Regardless of what the conditions are, be it inflation or deflation, investors should keep their focus on the long term and not take more risks than they can afford to. They must also keep in mind that market conditions are always changing and their portfolio has to change with them, or else it might not perform as it should.

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