Investors are rightly concerned about the recent level and persistency of inflation, which, depending on what metric one uses to measure it, is running at 4% to 5% year over year, well above the Federal Reserve’s long-term inflation target of 2%+ (to be fair to the Fed, our central bank has long made the case that a spike in inflation was expected – and would be tolerated – as the economy reopened, and that said spike would dissipate as supply caught up with demand; the Fed was spot on concerning the first half of its analysis and time will tell if its right on the second half).
While we don’t mean to dismiss the financial pain that higher prices for goods and services cause for millions of Americans, particularly those who spend a disproportionate amount of their income on day-to-day necessities such as gasoline and food, we would argue there is something more concerning for an economy than too much inflation and that is too little inflation—more specifically deflation—which is a decrease in consumer and asset prices over time. Deflation is unwelcome as it leads to lower consumer spending, which is the most meaningful contributor to US GDP (consider if you know the price of a good will be lower next year, you will wait to purchase it; when next year arrives and you know the price will be lower still in another year’s time you will again delay your purchase, and so on. That dynamic will force companies to cut back on productive resources, which will cause the economy to slow and eventually slip into a recession, while also making it very difficult for borrowers to service their debts).
Fortunately, deflation is rare, and last occurred in the US in a meaningful manner during the Great Depression, when consumer prices fell 10%+. We are concerned about the spike in prices for goods and services, but on a relative basis, it is much better than a dramatic drop in the price for goods and services.