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What is Deflation, Why Should You be Concerned -- And What Can You Do?


Prices on everything from gas to houses have fallen sharply in recent months, in what on the surface appears to be a good thing for American consumers. However, if prices continue falling on a widespread level, an event known as deflation, it could threaten the slumping economy significantly further.

low prices

Prices are getting lower for many consumer goods, but low prices over the long haul can further dampen the already struggling economy.

Why Lower Prices Aren’t Always a Good Thing

Deflation has been called “one of the most destructive forces that can hit an economy” by, and is an occurrence perhaps most associated with the Great Depression. In 1930, consumer prices decreased by over 2 percent, then went down 9 percent the next year.

While consumer prices are nowhere near falling at those levels (economists predicted the year-over-year decrease in January was 0.1 percent), there is some talk that deflation could get worse. As it is, as of February 2009 the Consumer Price Index is predicted to show the first year-over-year decrease in prices since 1955.

What does this mean for you?

It means you could be faced with lower prices at the mall and the gas pump. However, the major downside to deflation occurs when companies can no longer make a profit off of whatever it is they’re selling. This leads to cuts in production, job lay-offs, salary decreases, lower consumer spending and ultimately an increasingly shaky economy.

piggy bank

Worried about how your kids will fare financially in the future?

Read about the "Educational Toy of the Year" that will help teach your kids -- from infants to teens -- to manage their money for life!

Further, falling prices often persuade consumers to put off large purchases in hopes of getting an even better deal in the months to come, which further taxes the economy. Deflation also essentially makes the value of debts greater, since their value remains fixed while prices deflate.

For now, experts agree that the United States is only facing disinflation, which is a decrease in the pace of inflation and worse a potential complete reversal in trends. If the recession continues, serious deflation could be inevitable.

“At present what we have seen is disinflation but nothing at this time that suggests a real risk of deflation,” Dennis Lockhart, the Federal Reserve Bank of Atlanta President, told reporters.

He continued that while “prices have come down rather remarkably” right now “the inflation rate is at sort of an acceptable level.”

“We are watching for further price disinflation to a point where it might pose problems,” he said, calling deflation a concern, but “not a major concern.” Not yet.

Is There a Smart Solution?

While no one can predict exactly what the U.S. financial future holds, the old adage to “buy low, and not invest more than you can afford to lose” in a risky stock market, is still a prudent bet. Likewise, many investors are turning to gold and other precious metals as a more stable bet than the dollar.

piggy bank

Experts recommend having enough savings to live off of for three to six months in the event you become unemployed.

Gold, silver and other precious metals offer a sense of security, an insurance policy, if you will, that you will have something to fall back on if the economy crashes.

And even as consumer prices have been falling, gold prices have been rising. Whereas the price of gold was $713 an ounce in October 2008, in February 2009 it had risen to nearly $978.

"Gold is almost an insurance policy. It will always be there, and always pay,” Arthur Blumenthal, representative for Stack's, a Manhattan bullion and coin dealer, told USA Today.

Still, precious metals are known for being volatile and quite unpredictable.

Because of this, experts say you shouldn't tie up more than 5 percent (and certainly not more than 10 percent) of your investment money in gold, silver or other precious metals.

A few other sound financial tips include:

  • Work to assure you have savings in excess of 3 to 6 months or more of what you will need to pay your bills if you become unemployed.

  • Set up an automatic withdrawal from your monthly paycheck with your bank and employer so your savings automatically increases.

  • Invest in the stock market when the market is down as historically those who invest in the recession periods when the market is down gain the highest increased shares of stock value long term. Be certain the company stocks you buy are assured to survive these tough times or find and invest in a conservative mutual fund.

  • For your children or grandchildren set up a college fund account. Many have little to no taxation on gains during the period of the term of the savings up to college age of the child.

Recommended Reading

What Type of Investments are Worth Making in THIS Economy?

How to Make a Weak Economy Work Best for You

Sources February 20, 2009

Reuters UK February 20, 2009 February 19, 2009 February 18, 2009

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