- Inflation has been cooling for several months, but markets and the economy would suffer if sharp deflation sets in.
- Deflation can eat away at company earnings and margins, which would drive stock prices lower.
Inflation has plummeted from a blistering 9% last summer to 3% in June, and the stock market has rallied on hopes of a return to normalcy. But with prices still well above the Fed's target, policymakers have signaled more rate hikes are on the table.
That means there's a chance cooling inflation turns into outright deflation, which could eventually weigh on the labor market and stocks.
Disinflation — or the slowing pace of inflation — has continued throughout the year, with June's Consumer Price Index dropping to 3%. But on the producer side, certain data suggest deflation is around the corner, according to Kevin Gordon, a senior investment strategist at Charles Schwab. He pointed to the Producer Price Index in June dropping to 0.1%.
"It's too early to say when you may get deflation on the consumer side," he said. "A lot of people are wishing for that, so that the war on inflation can be won, but most economic downturns in history have deflation. Its a 'be careful what you wish for' scenario."
Deflation effectively comes down to how far your dollars can go. Mild deflation means consumers actually have stronger purchasing power. But Arthur Laffer Jr., president of Laffer Tengler Investments, noted that deflation stemming from a collapse in demand or high unemployment presents a much worse scenario.
"With mild deflation, consumers can buy more than before," Laffer said. "But if it's bad deflation, and people can't buy stuff because they're out of work, prices fall because demand is destroyed."
Main Street vs. Wall Street
Since most people look to headline CPI for a reading on inflation, many have wondered why the Fed plans to raise interest rates again, given that it's fallen more than expected in recent months and the central bank has hiked rates 10 times since March of 2022.
But Wall Street and policymakers, Gordon explained, are primarily targeting core personal consumption expenditures, which excludes food and energy prices. That provides insight into the stickiest parts of inflation.
"The numbers the Fed is looking at aren't anywhere close to deflation," the Schwab strategist said. "There's a disconnect between Main Street and Wall Street, but the Fed has made it clear that the risks of inflation coming back again outweigh the risk of a slower economy, and they definitely don't want inflation expectations to get embedded."
Deflation remains possible if the Fed hikes rates too much, or leaves rates elevated too long, and that could lead to cracks in the labor market. Over the last two years, companies have increased hiring amid soaring inflation, and they've raised wages to attract workers. But now, with most of those workers still employed and revenue and earnings beginning to roll over, something has to change.
"Widespread job loss will take income growth out of the economy, spending will slow, companies cut prices, and you get into a vicious cycle of inventory coming down and deflation," Gordon said.
Laffer added that the labor component is going to prove stubborn for the Fed, so it's possible we'll see price collapses in some sectors or commodities without seeing deflation across the board as employment and wage gains stay high.
Deflation and stocks
This week, Morgan Stanley's CIO warned deflation is coming, and that investors should brace for what the might mean for stocks after a year of rising prices gave firms the power to charge more for good and services, boosting earnings as a result.
Easing consumer and producer prices, which have fueled a huge stock rally this year and hopes for a soft-landing scenario, could fool investors into thinking the good news will keep on coming. But if disinflation does turn into deflation, that could present a headwind for corporate earnings, and thus, stocks prices.
"If your company had revenue growth and earnings growth last year, but then you took out inflation, and saw you had no actual growth in volume or unit sales, you have to find a way to make up for that," Gordon said. "Inherent in that is weaker earnings and weaker stock price."
To be sure, Laffer maintained that stocks could still go up in a mild deflation scenario, if prices are down somewhere between 2%-4%.
Ultimately, he anticipates falling prices to have a mixed impact, depending on the company.
"Deflation could cut into earnings growth and valuations, but it won't be even," Laffer said. "Some earnings will take a hit, but other people's earnings will come back. It's the change from inflation to deflation that hits companies hardest."