Despite a massive government spending program, interest rates at zero, and a range of extraordinary measures from the Fed, deflation appears to be taking hold. That's a worrying prospect. Here are three signs that the U.S. economy is teetering on the edge of a deflationary precipice, and one stock strategy to protect yourself under that scenario.

Sign No. 1: The Consumer Price Index (CPI)
The Consumer Price Index (CPI) is the best-known and most widely used measure of inflation in the U.S. Average prices for 2009 fell 0.4% year over year. The most recent CPI reading, for June, is higher than the year-ago figure by 1.1%, but it fell at an annualized rate of 1.2% compared to May.

Those rates are not dramatically negative, and they fall well short of the figures recorded during the early part of the Great Depression: In the three-year period from 1930-1932, prices fell by nearly one-fourth – an annualized rate of decline of 8.7%. All the same, the recent data bear the footprints of deflationary gremlins.

Sign No. 2: Company financials (or "Fun With Inventories")
Companies can account for their inventories in several ways, including FIFO (first in, first out) and LIFO (last in, first out). The difference between the two values is called the LIFO reserve. Changes in a company's LIFO reserve track the change in the cost of inventories, with a decrease indicating falling input prices.

Of the 34 companies in the S&P 500 for which the data is available, nearly half experienced a decrease in their LIFO reserve in the latest quarter. With annualized rates of decline of 0.2% and 0.6%, respectively, Goodrich (NYSE: GR) and Walgreen (NYSE: WAG) are examples of the disinflationary (if not outright deflationary) forces at work in the industrial and services sectors, among many other areas of the economy.

Sign No. 3: The money supply
The rate of growth in the M2 money supply measure (currency, deposits, and retail money market funds) has been slowing. In June, the 12-month increase was just 1.8%. However, the broader M3 measure is now shrinking at an annualized rate of 6%, according to Shadow Government Statistics, a research firm that tracks this discontinued measure. M3 began shrinking last December, according to Shadow Stats. When a smaller amount of money is chasing the same amount of goods and services, you have the recipe for deflation.

One market that sees inflation on the horizon
At least one market-based indicator doesn't confirm a deflationary scenario. TIPS are Treasury bonds with interest and principal payments indexed to inflation. By comparing the real yield on TIPS to that on ordinary Treasury bonds of similar maturity, one can derive the TIPS market's estimate of future inflation, known as the "breakeven" inflation rate.

On Monday, the 10-year breakeven inflation rate stood at 1.8% per year -- low by historical standards, but not deflationary by any means. One possible explanation for this discrepancy: The difference in size between the T-bond and the TIPS markets could be skewing the breakeven inflation rate upward. Large demand for TIPS may be having a disproportionate price effect on the much smaller market, since TIPS represent just 7% of total U.S. debt.

It may also reflect widespread disagreement -- and in some cases, confusion -- over whether inflation or deflation lies in store for us. Certainly, this crisis has already produced numerous odd or seemingly contradictory market phenomena.

A deflation-beating strategy
If we enter a period of deflation -- which seems increasingly likely -- the best stocks to own represent companies with low debt and a defensible franchise. Stocks that pay an above-average dividend yield are particularly attractive, since deflation raises the real value of the dividends shareholders receive.

Approximately one in nine companies in the S&P 500 sports a dividend yield that exceeds the current yield on the 30-year Treasury bond (4.03%). Of these, only 19 have less debt than equity on their balance sheets, including:


Dividend Yield

Total Debt/ Equity (%)

Merck (NYSE: MRK)



Bristol-Myers Squibb (NYSE: BMY)



Eli Lilly (NYSE: LLY)



Leggett & Platt (NYSE: LEG)



Exelon (NYSE: EXC)



Source: Capital IQ, a division of Standard & Poor's.

These stocks are consistent with the high-quality-plus-income theme I have been pushing for some time. But what if a proper bout of deflation doesn't materialize, and inflation begins to crank up instead? Would this strategy be a big loser?

A flexible strategy for uncertain times
Thankfully, high-quality income stocks pay off no matter which way prices move. Indeed, a defensible franchise creates pricing power that enables these businesses to maintain prices in a deflationary environment, and raise prices at a rate that matches or exceeds inflation. In an economic environment with precious little certainty about anything, Fools should highly prize that sort of flexibility.

With the recovery stalling and the economy on the brink of deflation, sustainable dividends will become increasingly valuable. Jordan DiPietro has identified the best dividend stock. Period. 

Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the stocks mentioned in this article. Exelon is a Motley Fool Inside Valueselection. Motley Fool Options has recommended writing puts on Exelon. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.