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Is Deflation Now "The Peril?" And What Do You Do if It Is?

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The Seven Faces of The Peril may never outsell the Twilight Series, but as economic white papers go, it's pretty Gothic. The author is James Bullard, the president of the St. Louis Federal Reserve Bank, and it caused a few ripples on Wall Street when it was published last week. The money quote is, "The U.S. is closer to a Japanese-style outcome than at any time in recent history." A Japanese-style outcome, in case you're wondering, means the economy gets stuck in a deflationary trap that lasts for all eternity. It's like being a vampire, only it's your blood that gets sucked out of you.

In a deflation, prices of goods and services fall in a vicious cycle of economic contraction, unemployment, and falling stock prices. Deflating prices keep people from buying, since they recognize they can get everything cheaper later, and the postponed sales only make businesses more desperate to sell, so they lower prices again. And so on. Japan has been on this treadmill for over a decade. If you're saving for retirement, this is just about the worst case scenario

Even before Bullard showed up, the deflation camp had plenty of prominent followers. Faithful users of CBS MoneyWatch will remember economist Carmen Rinehart raising specter of "The Peril" in this interview a year ago. Paul Krugman has been flogging the D-word for months in the New York Times. The "New Normal" scenario of Pimco's Bill Gross and Mohammed El-Erian is just one step away from deflation, as is the "Seven Lean Years" scenario of Jeremy Grantham. So Bullard's paper isn't lunatic fringe. While Bullard himself thinks it's less than a 50-50 proposition, you can't ignore the risk.

Ah, but what do you do about it?

The classic investment response to deflation is to invest in Treasuries. Why? Because you know that Uncle Sam will make good on his IOUs, even in a deflationary downturn. Because the value of dollars increases as prices fall, the bonds protect your standard of living. The problem with Treasuries now is, they yield next to nothing: the five year note is at 1.5% as I write. That kind of yield only makes sense if deflation holds sway. If inflation happens instead and interest rates rise, you're stuck.

So again, what do you do?

1. Admit that you don't know what's going to happen, and hedge your bets. Bullard, Grantham, Krugman, and the other deflationistas are smart guys, but there are plenty of equally smart guys who think inflation is the bigger risk. So you need to own some government bonds (your deflation hedge) and some stocks, possibly along with commodities (together, they're your inflation hedge). For the former, consider iShares Barclays Aggregate Bond ETF (AGG), for the latter Vanguard Total Stock Market Index (VGTSX) or Harbor Real Return (HACMX). Admit to yourself that you're not going to make money on both hedges at the same time. One will pay off. The other will be insurance. But that's not bad investing. That's good investing.

2. Favor corners of the market that cover you without taking too much risk. Some investments will hold up relatively well in either a deflation disaster or an inflationary inferno.
  • Jeremy Grantham and Jim Grant, among others, favor high-quality dividend paying stocks as a kind of bond substitute. Solid blue-chips like Johnson & Johnson (JNJ) pay handily more than five-year Treasuries, and they can raise prices during an inflationary spiral. Bonds can't. T. Rowe Price Equity Income (PRFDX) would do the trick.
  • Gross and El-Erian recommend getting some of your government bond exposure from Canada and Australia, two developed countries that have reasonably balanced budgets and healthier economies than ours (and possible real estate bubbles, so they're not risk free). You can invest alongside Gross and El-Erian in Harbor Bond fund (HABDX), a Morningstar analyst's pick.
  • Grantham and Gross lean towards the stocks and bonds of emerging markets, where economies are still growing and, generally speaking, the government debt is less crippling than in the U.S., the U.K. and most of Europe. China, India, Brazil and the likes are nobody's idea of a steady investment. But they're less susceptible to The Peril, and that makes them a hedge, though a particularly rocky one. T. Rowe Price Emerging Markets Fund (PRMSX) is endorsed by Morningstar in this category.
3. Finally, remember rule number one. You don't know what's going to happen, and neither do the deflationistas, smart as they are. Spread your risks out as broadly as you can and don't go whole hog into anything. The goal is to feel vindicated if you're right -- but to survive if you're wrong.