How likely is there going to be a deflation threat?

Cathie woods has been citing that the biggest threat to the US economy is deflation since 2021. However, since Ark invest funds are getting hammered her remarks are getting ignored and laughed at. With record high inflation and interest rate, a strong labor market, and contracting Real GDP growth, this is an unprecedented time we live in. Hence in this blog post, we are going to discuss the likely hood of a deflationary threat.

#1 Increasing Inventory from big retailers.

Source:census.gov

In May 2022, “Inventories to Sale*” was reported at 1.26. This number was higher than in May 2021. In essence, A high “inventories to Sale” number implies a decrease in consumer spending.

What caused the decrease in the Consumer spending rate?

Before we can conclude anything, let’s review the economical events that lead to the reported 1.26. 

  • In march 2020, the US government started issuing stimulus relief. American Rescue Plan was also introduced. This plan includes a Child tax credit and expanded unemployment benefits. These aids only ended in September 2021 (source:cnbc).
  • Going into the pandemic lockdown, we saw inflation due to excess money supply and supply shortage due to supply chain disruptions. We also saw a record number of first-time investors entering the market (source: fool). With this abundance of money and limited spending option(due to lockdown), we saw the stock market reaching a record high price until December  2021. This was dubbed “Assets inflation according to some economists”. However, this asset inflation only benefited those who already owned assets before the crisis. Therefore widening the wealth inequality.

    Source: Statista
  • Also going into the lockdown, people couldn’t spend money on services like traveling. Hence the only means for people to spend money are on products. This would result in a high inventory turnover rate.
  • Going into 2022, the expectation of a tightening of federal monetary policies marks the beginning of the market bearish sediments. May 2022 marks the start of the first of many interest rate hikes. Despite the oil and food disruption caused by the Russians & Ukraine war that started in February.
  • The decrease in inventory turnover rate is caused by sustained high inflation and an increase in interest rate. Historically speaking these two Marco factors are inversely correlated. However, due to:
      1. Record high M2 money supply.

        Source:M2
      2. A sudden demand disruption due to 
        • Russian vs Ukraine
        • China zero policy
        • Dieasterious climate conditions hindered crop yield globally.
        • Sri Lanka’s economical collapse(they were a major player in agriculture export)

We entered demand-pull inflation in 2022, while we were still in cost-pull inflation. Thus raising interest rate ain’t yielding historical expectation.

In summary, the decrease in consumer spending is due to

  1. wealth inequality. There is only so much stuff the wealthy people can buy. Right now cash and short-term bonds seem to be their favorite items
  2. According to Statista, the Bottom 50% controls 2.8% of the wealth in America. With consumer discretionary goods at an inflated price, and housing loans becoming increasingly more expensive to pay off, there is just not enough money to spend on other unnecessary items.

#2 Strong labor market but Low saving rate


Source:BIS

Source:Fred

The low unemployment rate for June 2022. The unemployment rate and Non-farm payroll have gone back to pre-pandemic levels. Even the employment numbers in the retail sector seemed to be back up!


Source:Fred

However, the Personal saving rate has been declining quite rapidly, about 2% lower than the pre-pandemic(COVID) level as of June 2022. 

Source:Statista

This is because even with the wage increase, the rapid rise of inflation has caused people’s purchasing power to diminish. Most people don’t have as much money left over after purchasing necessary consumer discretionary goods. 

The low unemployment numbers although contradictory to a weaker economy could be explained by companies hoarding labor as the USA just exited an “anti-work” and labor recruitment is getting tougher as people are prioritising mental health now.  


Source:BEA

As Real GDP continues to contract, I expect the unemployment numbers will rise.

#3 Stronger dollar and higher interest rate

As the threat of a global recession loom, foreign investors flock toward the US dollar to safe harbor, because

  1. US currency is the world reserve
  2. The recent increase rate hikes also make US fix-income security more attractive.

However, this will be at the expense of US exports. As the price of US exports would not be as competitive as the international markets. Thus making it a harder sell.

Conclusion 

 It would appear that some deflationary forces are indeed brewing underneath. According to textbook economic theory,

  1. With wealth inequality progressively worsening, The tiny population of people who have money is keeping them in cash or assets. As the Feds are unwinding their balance sheet, resulting in a reduced money supply.
  2. Companies will start to slash prices to increase inventory turnover. However, because of Inflation in food and energy from demand-pull (Which are not included in the core CPI index), attractive discounts might not be enough to see high inventory sales. Middle/low-income population diminishing purchasing power, just don’t have enough money to spend on other items. Therefore decline in consumer confidence.
  3. A global recession is also brewing underneath as most countries forecast weaker GDP growth.

However, the chances of deflation happening is still very low and I would think very unlikely. I think there will be a period of readjustment but not to the extent of deflation. This is because even though we met 3 of the textbook signs of a deflationary climate, it’s all happening after unprecedented money supply and growth in 2019,2020 & 2021.