09/07/2010 01:10 pm ET | Updated May 25, 2011

Deflation and Bank Rates: Good or Bad news for Depositors?

Now that the economic recovery has lost momentum, talk in the financial press has returned to the possibility of deflation. To generations raised to fear inflation, the prospect of falling prices doesn't sound so bad -- after all, that means the funds in your savings accounts will stretch further, right? However, deflation can be a symptom of larger economic ills and a destabilizing force in its own right.

For bank depositors, the silver lining is that they have little to lose from deflation right now.

What's wrong with falling prices?

Everybody loves a bargain, so what could be wrong with falling prices? In isolated cases, nothing -- but when prices fall steadily across the economy, there are two problems:

  • If prices are consistently falling, it is a symptom of wider ills in the economy, most notably slack demand. Weak demand has been the defining problem with the economy over the first half of 2010, as fiscal and monetary stimulus have found little traction. A return to deflation now would almost certainly be a sign of a double-dip recession.
  • Falling prices may be good for consumers, but not for businesses. Right now, the business sector of the economy is healthier than consumers or the government. However, faced with the prospect of falling prices for the goods or services they offer, businesses will be reluctant to raise their costs by hiring or investing. That would further impede economic recovery.

Bank rates and deflation

Normally, the prospect of deflation would mean lower bank rates. However, with the FDIC's reported national average savings account rates and 1-month CD rates already below 0.20%, and money market rates not much higher, bank rates don't have much ground to lose. In the near term, then, a return to deflation would actually mean that depositors would be able to rebuild purchasing power.

In the long run, though, deflation could leave depositors pretty much stuck in neutral--not losing ground to inflation, but not earning much either. In short, it's OK for depositors to welcome a little bit of deflation, but just be wary of too much of a good thing.

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