If you listen to Fed talk, inflation is still the biggest problem this economy faces. If you listen to the markets – not so much. Last week, we noticed several references to deflation that caught our attention.

Wait, what? What happened to disinflation, did we just skip over that phase?

While some pundits have been banging deflation drum for a while (Cathy Wood of Ark fame — The Real Enemy – Deflation — for instance), it was Walmart’s CEO’s comments on its 3Q23 earnings call that made us take notice. Among other things, Doug McMillon stated “[i]n the U.S., we may be managing through a period of deflation in the months to come…and while that would put more unit pressure on us, we welcome it, because it’s better for our customers.”

Now companies face a headwind to margins which may, in fact, finally slow earnings growth. We warned as much in our blog in August 2022 (Is the Market Crying Wolf on Long-Term Inflation?), although admittedly, we were a little early.

Could the Fed actually have been right 18 months ago? Was inflation transitory? A viewpoint widely considered clueless — akin to an ostrich with its head in the sand — and even dangerous.

The Fed, and many economists have gotten things terribly wrong in terms of their ability to forecast economic activity, almost as far back as we can remember. No doubt, it’s a tough game. Models, however sophisticated, are just models and rely on assumptions, probabilities, and historical pattern recognition. We have always felt that modeling a complex system is not really about predictive value, but rather understanding the dynamics of a system and how they might respond to certain stimuli. Certainly, they are worth building. However, much like the COVID models that we were expected to accept as sacrosanct, we must remember they are flawed and works in progress.

Again, useful but not fact.

The dawn of artificial intelligence (“AI”) will likely result in better models with higher predictive value, but it’s unlikely that complex systems can be re-created in full – after all these years, we still can’t predict the weather!

And in the back of our minds it has always been the thought that the advancement of technology is inherently deflationary. The Fed fought for many years just to get inflation close to 2% and didn’t succeed. It took a 100-year pandemic and our collective, and somewhat disjointed, response to the crisis (including lockdowns) to change the equation. But as we have generally returned to “normal”, why wouldn’t the same influences that tamed inflation take over once again? The rise of AI, while increasing productivity, will be another driving force for deflation for some time to come. We are skeptical that this revolution will simply make us all more productive without increasing unemployment as many suggest. Over time, AI should have a negative impact on wages as a whole.

The only hesitation we have to the deflation thesis is deglobalization. We are big fans of Peter Zeihan’s “The End of the World is Just the Beginning”, which suggests that we have experienced a unique period of prosperity since the end of World War II, largely as a result of the Breton Woods Accord. Essentially, in exchange for peace, the US was willing to sacrifice its own growth, provide access to the world’s largest market and ensure the smooth flow of goods and resources globally. The end of this dramatically productive period, hastened by the COVID experience, will make moving goods and services around the globe much more difficult and much more expensive, in some cases prohibitively so. We find his logic extremely persuasive. In short, this is all very inflationary.
The Fed tends to always be fighting the last war.

In the end, we have the same concern we’ve always had, because of the Fed’s reliance on lagging data and long and variable lags to policy. Yet they are likely to go too far, holding onto their inflationary narrative until it’s too late to pivot. In the long run, deflation is the real villain.

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