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The Double-Edged Sword of Falling Inflation: A Potential Swing to Deflation

A sigh of relief swept across the markets as inflation rates took a nosedive from a staggering 9% last summer to a more subdued 3% in June, sparking a stock market rally. Yet, with consumer prices still soaring above the Fed’s target, the indication of further rate hikes is clear, raising concerns of a potential shift from soothing disinflation to chilling deflation.

The phenomenon of disinflation – the slowing pace of inflation – has persisted this year, with June’s Consumer Price Index (CPI) moderating to 3%. Meanwhile, Kevin Gordon, a senior investment strategist at Charles Schwab, hints at lurking deflationary tendencies evidenced by the Producer Price Index in June inching down to 0.1%.

Gordon advises caution, saying, “A lot of people are wishing for deflation, so that the war on inflation can be won, but most economic downturns in history have deflation. It’s a ‘be careful what you wish for’ scenario.”

Deflation fundamentally translates to how far your dollars can stretch. Mild deflation can actually enhance consumer purchasing power. However, Arthur Laffer Jr., president of Laffer Tengler Investments, notes the dark side of deflation, which can surface from a collapse in demand or high unemployment.

The clash of Main Street and Wall Street perceptions on inflation has raised questions about the Fed’s plans for further rate hikes, particularly as CPI has dropped more than anticipated recently. However, Wall Street and policymakers focus on core personal consumption expenditures, excluding volatile food and energy prices.

Despite the current cooling of inflation, the threat of its return has kept the Fed on its toes. The central bank is wary of a sluggish economy but views the revival of inflation as a greater risk.

A deflationary scenario could unfold if the Fed oversteps with rate hikes or maintains elevated rates for too long, potentially destabilizing the labor market. The hiring spree amid soaring inflation in the last two years has now left companies grappling with an employed workforce, rolling revenues and earnings, and the impending need for change.

As Gordon warns, “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.”

Considering the potential impact on stocks, Morgan Stanley’s CIO alerts investors to brace for potential deflation. The current stock rally driven by easing consumer and producer prices could make investors complacent, but a shift from disinflation to deflation could create headwinds for corporate earnings, and thus, stock prices.

Laffer, however, suggests that stocks could still gain in a mild deflation scenario. He foresees falling prices having varied impacts on different companies, emphasizing, “It’s the change from inflation to deflation that hits companies hardest.”

As we tiptoe along the edge of the inflation-deflation spectrum, one thing is clear: whether it’s inflation or deflation, the road ahead will be a bumpy ride for both businesses and consumers alike.