What Deflation Means for Consumers

Few consumers are going to be upset, of course, to walk into the local warehouse store and find that food, clothing and gadgets have all gotten cheaper. But during prolonged deflationary times, that glow isn't likely to last long. Companies making those goods will want to pay their workers less, and their competitors will follow suit. The next thing you know, your paycheck is smaller.

A big priority for consumers if deflation settles in should be reducing debt, or at the very least being ultra-careful not to incur more of it. In a society where consumers have hungrily tapped credit cards and taken out home equity loans in recent years, this is a big shift.

"You don't want to be in debt when you're going through a period of deflation, because income growth is much more stagnant," says Sheryl King, senior U.S. economist at Merrill Lynch.

During the Depression, unemployment reached 25%. That kind of jobless rate ultimately means consumers will have a harder time repaying fixed amounts of debt. For instance, you might currently use 50% of your income to pay a mortgage but have assumed that was OK because you expect your income to rise over time (with inflation). In a deflationary period, the opposite is true as your income stagnates or even falls -- and debt takes up a bigger portion of it.

So even if deflation doesn't hit hard, now is probably the time to start paying off those credit cards, putting extra cash to the mortgage and avoiding unneeded loans.

To a degree, "consumers are already doing this," says Doug Roberts, chief investment strategist for Channel Capital Research. This sort of consumer retrenching can be a good thing, so long as it doesn't lead to hoarding cash, which keeps demand low and the cycle going.

"[W]hen [deflation] starts to permeate and you see wage growth go down, prices down across the board," he says, "at that point it means the economy is tightening and getting worse."

In other words, deflation can become self-fulfilling. It's one thing if consumers stop living off credit. It's another if they put off buying the already discounted jumbo pack of paper towels at Costco this week because they expect it to be even cheaper next week.

A good rule of thumb: Any spending that requires you to take on added debt and isn't an investment -- such as a new car, which will depreciate in value -- is probably not the best idea right now. This is especially true if you don't have very strong credit, as interest rates will be higher for riskier borrowers. Credit-card companies are also raising fees and rates, making even small purchases on borrowed money less than worth it.