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Liz Pulliam Weston

The Basics

Inflation: Who wins, who loses and how to cope

Fears of the inflation monster are beginning to creep in even as wages are largely stagnant and some prices are dropping. It's time for an inflation game plan.

By Liz Pulliam Weston
MSN Money

Right now, there are more home sellers than buyers, more jobless than job openings and more factories making goods than buyers for those goods. It's easy to see why prices, if not falling, have all but stopped rising.

Who doesn't like lower prices? Economists, for one.

Deflation is what took hold in the Great Depression, leading to lower wages, higher unemployment and more loan defaults. (It gets tougher to pay your loans when you have fewer dollars to do so.) Deflation tends to feed on itself; once it takes hold, it's hard to stop.

The good news is that many economists think the biggest deflation risk has passed. The government has poured more than $1 trillion into the mix to prop up jobs, home prices and consumer spending. But once the economy starts to pick up, the worry is that there will be lots of dollars chasing after goods and services plus more willingness to spend them, which will bid prices up.

So far, there doesn't seem to be much cause for concern. The core Consumer Price Index has risen just 1.4% in the past 12 months, and most economists don't see inflation accelerating anytime soon.

When waiting to buy meant paying more

If the Fed gets it wrong and doesn't pull back fast enough when the economy takes off, we could see inflation like we haven't seen in years. Even the Fed's efforts to ward off inflation might bring the kind of rising interest rates and prices we last experienced in the late 1970s and early 1980s.

Here's just a sample of what life was like back then:

  • Prices increased 40% in just three years, from 1979 through 1981. Every trip to the grocery store, it seemed, resulted in a bigger bill.

  • The prime interest rate, now 6.75%, peaked at 21.5% in December 1980. Borrowing became prohibitively expensive as the Fed tried to break inflation's back by raising rates sky-high to choke off demand.

  • Fixed-rate mortgages, currently hovering around 5.5%, averaged 17.5% in 1982. That means the payment on a $200,000 mortgage back then was $2,933, compared with less than $1,133 at today's rates.

What real inflation looks like
YearInflationYearInflation

1973

6.2%

1979

11.2%

1974

11.0%

1980

13.6%

1975

9.2%

1981

10.4%

1976

5.8%

1982

6.2%

1977

6.5%

1983

3.2%

1978

7.6%

1984

4.3%

Source: Bureau of Labor Statistics

Who hurts, who prospers

If you don't remember those days, you have plenty of company. More than half of the U.S. population is under 40, so many people either weren't born or were just kids when inflation took big bites out of their parents' budgets.

Because so many of us have never dealt with serious inflation and the rest of us are out of practice, it's time to review the basics: who wins, who loses and how best to cope.

When inflation starts eroding the purchasing power of the dollar, the folks most at risk include:

  • People on fixed incomes. Social Security and disability checks may have cost-of-living increases built in, but those typically lag the actual inflation rate, which can spell some tight times. People living on income from certificates of deposit and other cash savings may see their yields climb but, again, at less than the inflation rate.

  • The poor. The less money you make, the more of your budget is spent on basics such as food, shelter, clothing and transportation, and the less flexibility you have to deal with rising prices.

  • Holders of long-term bonds. Rising rates drive down the value of older, lower-paying bonds. The longer the term of the bond, the bigger the hit it can take.

  • People with variable-rate debt. Interest rates aren't fixed on most credit cards and home equity borrowing; many mortgages have adjustable rates as well. That means rising payments.

The winners? Folks with fixed-rate debt, which gets easier to repay with ever-cheaper dollars, and those who have investments that can beat the rate of inflation.

Your inflation game plan

So here are the lessons to be learned when dealing with inflation:

  • Don't rush to pay off your fixed-rate debt. Even at modest inflation rates, the payments on fixed-rate mortgages, auto loans and other debt get cheaper every year. If prices continue to accelerate, the mortgage payment that seems so monumental today will quickly start to feel like a bargain.

  • Beware of locking in low rates on savings. If inflation does return, you'll be sorry you bought long-term bonds or certificates of deposit at lower rates. Consider laddering your fixed-income investments, which means buying bonds or CDs with staggered maturities. If you have CDs maturing every few months, you'll be able to take advantage of higher rates should they come.

  • Get ready to substitute. Prices for different goods and services rise at different rates, which means savvy shoppers have opportunities to substitute relatively cheaper items for more-expensive ones. Eggs, for example, rose nearly 50% after Hurricane Katrina devastated many of the nation's poultry producers; price-conscious consumers ate more oatmeal for breakfast. All the ways frugal folks have traditionally found to save money become even more helpful as prices soar.

  • Weigh the cost of procrastination. Today's consumers are used to being rewarded for waiting. Delay buying that computer, for example, and you'll get a better, more powerful one for less next year.

In an inflationary environment, though, rising prices reward those who don't procrastinate.

Obviously, you'll want to keep living within your means, and you don't want to finance these purchases with variable-rate debt, like credit cards. But should inflation reignite, the scales will start to tip in favor of buying sooner rather than later.

  • Get real. Investments in so-called "real assets" -- real estate, natural resources and commodities -- can help you hedge against inflation. Just don't go overboard, because these assets are notoriously volatile. For all the hubbub about gold, for example, prices for that precious metal still haven't come anywhere close to regaining the peak hit in January 1980, when the per-ounce price was $850 -- or about $2,225 in today's dollars. (Check today's gold prices here; they've soared about 40% since the meltdown began last year.)

  • Stay invested in stocks. The slightest hint of accelerating inflation often sends the stock market into a tizzy, which has given some investors the mistaken notion that equities are a bad place to be in an inflationary environment.

In reality, stocks did pretty well during the country's last bout with significant inflation, posting double-digit returns in six out of the 10 years during the inflationary decade starting in 1974. Over the long haul, most investors need the inflation-beating returns stocks provide if they want to reach their retirement and other goals.

Stocks versus bonds during the inflation years
YearS&P 500Long-term bondsYearS&P 500Long-term bonds
1974-26.47%4.35%197918.44%-1.23%
197537.20%9.20%198032.42%-3.95%
197623.84%16.75%1981-4.91%1.86%
1977-7.18%-0.69%198221.41%40.36%
19786.56%-1.18%198322.51%0.65%

Source: Ibbotson Associates

Don't eschew bonds. Even though bonds tend to suffer when rates rise, they're important to most people's portfolios. They can provide a cushion against stock market volatility. And when they fall in value, they tend to fall far less than stocks.

Finally, remember that nothing is certain. The Fed may get it right and siphon money out of the system without creating havoc. If not, though, at least you'll know what to do.

Liz Pulliam Weston is the Web's most-read personal-finance writer. She is the author of several books, most recently "Your Credit Score: Your Money & What's at Stake." Weston's award-winning columns appear every Monday and Thursday, exclusively on MSN Money. She also answers reader questions on the Your Money message board.

Updated Oct. 1, 2009

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