My body is using the muscle, so it still needs it so it won't break it down for energy as quickly.
I've on 1000 calories or so per day for well over a month now, and my lifts have gone up (granted, not by much). So I'm pretty sure it isn't impairing my strength
You loose more muscle if you don't do any gym time and just diet, you'll loose more muscle than fat!. (because if you aren't using it, it's excess, and causing your body to be inefficient, so when starved your body will burn it up for energy and to increase efficiency)
My scales do bodyfat% too, and it's gone down, but I haven't really been paying too much attention to it, because the level of hydration will have a big effect on the reading (not to mention they are never terribly accurate anyway). I can see that I'm loosing fat
Good stuff on the squat stands. Make sure to get the technique down first before building up the weight.