(MONEY Magazine) – Ask the typical Wall Street savant about Japan's decade-long battle with deflation, and he'll argue that it can't occur here. Our central bankers at the Federal Reserve are too vigilant and our bankruptcy laws too progressive for deflation ever to take root in the U.S. With the Fed slashing interest rates and bankruptcy laws allowing lenders to cut their losses and redirect capital to worthier ventures, a sustained decline in GDP--and accompanying decline in prices--is unlikely.

Michael Cheah isn't so sure. The manager of SunAmerica's GNMA and Government Securities funds, Cheah spent 17 years as a central banker in Singapore before entering the mutual fund business in 1999. The way Cheah sees it, there are clear parallels between the U.S. today and Japan in the early 1990s--namely, enormous industrial overcapacity (depressing prices) and banks that are reluctant to lend money (hampering growth). These parallels led Cheah to make an aggressive bet on falling rates in 2002. The move paid off last year, when SunAmerica GNMA was the top-performing Ginnie Mae fund, returning 11.5%. (Ginnie Maes are mortgage-backed securities guaranteed by the Government National Mortgage Association.) This year, with rates moving up, the fund has gained only 1.2%, but that's still better than 80% of its peers. MONEY senior writer Jon Birger caught up with Cheah to get his unconventional take on interest rates, deflation and the Fed.

THE FED'S OUTLOOK

Q. If Alan Greenspan is optimistic about the economy, why aren't you?

A. When the Federal Reserve chairman is speaking to Congress [as he did in July], he knows that he is talking to the political masters and that he obviously cannot afford to paint the economy in a way that may undermine confidence. But if you look at the text of his speech and the underlying theme, it's still clear that they're going to leave interest rates low for a long time. In fact, when one of the congressmen pressed him on inflation, Greenspan made it very clear that inflation is far, far away.

Q. The market doesn't seem to agree--10-year Treasury yields are up one percentage point since June.

A. The bond market has overreacted. The Fed is still very concerned about deflation. [Fed governor Benjamin] Bernanke said that even if we get strong growth for the next two years, he expects inflation to continue to drop. [Dallas Fed president Robert] McTeer said there is no hard evidence the economy is improving.

Q. If the economy does improve, won't the Fed quickly move to raise rates?

A. The Fed sees its success fighting inflation as too much of a good thing. They've seen core inflation falling from 3% to 2.5% to 2% and now to almost 1%. It's a scary way to go. As a former central banker, I can tell you that central banks' modus operandi has always been biased toward making decisions they can undo. Right now if the Fed were to allow rates to remain low too long, overstimulating the economy, it's okay because they can correct that mistake. Whereas if the Fed were to wait too long and allow the economy to fall into deflation, it's very hard to correct.

THE TWILIGHT ZONE

Q. Is deflation really that much harder to remedy than inflation?

A. I compare it to what happens to water when the temperature drops. Not much happens from 3C to 2 to 1. But once you get to zero, water freezes. Similarly, once you cross the line into deflation, everything changes. We've all been taught, for example, that when prices fall, demand goes up. Every first-year economics student knows that. But in a deflationary twilight zone, when prices drop, consumers don't buy. They believe the price will go even lower tomorrow.

Q. So it pays to do nothing.

A. Exactly. We've all been trained that the economy runs because people have this animal spirit to do something. But in a deflationary world, when you have money and you don't spend it, you're rewarded because the same money can buy you more goods tomorrow.

Think of the entrepreneur who opens a business. He buys inventory, and the next day whatever he bought becomes cheaper through no fault of his own. That punishes the animal spirit--something we don't want to see.

Q. Is the Fed doing all that it can to prevent deflation from occurring?

A. I would like to see even more Fed action than we've seen so far, in terms of rate cuts and even in terms of outright buying of 10-year Treasuries.

I always analyze the economy in terms of the four engines of growth--consumer spending, investment spending, government spending and net exports. The only one working now is the consumer. But now he's seen his neighbors being fired, he hasn't gotten a pay raise, and all he has at the moment is mortgage refinancing. So the Fed doing more at this stage would help to sustain growth. The 25 basis point [rate reduction in June] was good, but if they had cut more, it would have been better.

Q. Bulls tend to believe Japan's deflation is a fluke--a byproduct of mismanaged banks, bumbling central bankers and weak bankruptcy laws. You disagree.

A. I do. I know the senior people at [Japan's central bank]. Most of them come from Tokyo University, which is Japan's Stanford and Harvard put together. They are very smart people, and they're being advised by some of the best minds in the world--including Milton Friedman. And yet they have not seen any success.

Even if Japan is different, it doesn't give us the right to be complacent. I could come up with many arguments that we are more like Japan than we are unlike Japan. For example, in Japan one of the weaknesses has been banks' unwillingness to lend. Here I see commercial and industrial loans falling and banks buying more and more mortgage-backed securities. At the end of the day, if rate cuts are to be effective, the money must flow from the banks to the rest of the economy. Well, do you see credit-card rates coming down?

Q. No, I don't. But what about Japan's weak bankruptcy laws, which, some argue, have prolonged Japan's slump by discouraging banks from cutting off funding to foundering companies?

A. Does Chapter 11 really solve our own overcapacity problem? Chapter 11 may restructure a company, but in the real world, the overcapacity remains. If an airline were to file Chapter 11 tonight, the number of airplanes remains the same.

BORROWING PAINS

Q. How likely is deflation?

A. Even if it's only a 5% chance, it's important for financial planners and consumers to be aware of the potential problem. In a deflationary environment, the most pain goes to those who borrow the most. If that means I should pay down my debts, then let's start now.

Q. In your Ginnie Mae fund you've been stocking up on low-coupon bonds. [Coupons are the periodic interest payments due bondholders.] Why?

A. A lot of us are benefiting from mortgage refinancing, but it's important to think about the flip side. As an investor, you don't want to be holding high-coupon mortgages that are most at risk of being refinanced.

Q. What don't you like bondwise?

A. I'm avoiding corporate bonds, partly because of my deflationary fears. With [corporates yielding so little relative to Treasuries], the risk, as I see it, is enormous, and the reward isn't really there.