A Contrarian Hypothesis: Deflationary Whiplash

Credit: Dominik Lückmann

While our attention, motivated by media headlines, is focused on rising inflation, I humbly believe there is an equally high risk of a deflationary shock to the economy in the coming months and quarters. I worry that it is such a shock that could trigger the next recessionary cycle. Let me explain my thinking.

Yes, interest rates are at all-time lows and are a factor in inflating especially housing. I certainly can’t discount that and have written quite a bit about my concerns about negative real rates, money printing, and the devaluation of currency in the long run.

What I believe we are overlooking is the whiplash effect that COVID has had on the economy. In March of 2020, we shocked the system by shutting down demand to nearly everything: travel, dining, gasoline consumption, cars & truck purchases, personal care services, and more.

Many businesses, dealing with the uncertainty of demand, reacted quickly by shutting down their supply chains and, in some cases, laying off workers. We “winterized” the economy over a matter of weeks.

With the unprecedented pace of vaccine development and rollout in the US, nearly as quickly as demand was shut down a year ago, it has returned with a vengeance in 2021. After a year’s consumption hiatus, the American consumer is ravenous in their desire for travel, bikes, RVs, cars, consumer goods, and, yes, homes along with just about everything.

That unexpected demand is pulling on supply chains that are struggling to restart. After laying off workers a year ago, businesses are hiring anyone and everyone in an attempt to scale up to meet the demand. In fact, in many cases, they’re over-ordering knowing that it’ll be weeks and months before they receive their orders. If you’re a bike shop, why order 50 bikes to sell if you believe you can sell every one? Why not order 250 now? This pattern is pervasive across the economy.

But this excessive demand is artificial. It will not and cannot continue for many more months let alone quarters or years.

What will happen to these overstuffed supply chains when demand normalizes? Businesses may be forced to adjust very quickly as they realize they have scaled their staffing and inventories to demand levels that aren’t sustainable. And, once again, they may over-correct and over-react. If we can’t manage that correction, we may trigger a painful recession that would include price deflation on nearly everything that is currently inflating hyperbolically.

We have created a Whiplash Economy with higher highs and lower lows. That stark and accelerating oscillation is incredibly difficult for our regulators to manage.

What can we each do to help minimize the impact? In my humble opinion, the best path forward is for each of us to do our best not to be brash in either direction: not to over-invest when things are going up and not to under-invest when things are going down. As a business owner, I didn’t lay off anyone when the economy ground to a halt last year, and I will not simply hire anyone and everyone now as the economy is overheating. My personal plan is to stay tempered, stay reasoned, and play the long game.

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