- Technology is deflationary primarily because it allows the production of goods and services to scale efficiently.
- Long-term price inflation of a particular good or service becomes an impossibility when the production of that good or service can scale to meet 100% of current and future demand.
- As technology enables more and more industries to reach that inflection point, there will be less and less price inflation across the market as a whole.
- Short bursts of industry-specific inflation may continue to occur, but I predict that they will be less severe and last for shorter lengths of time.
- I am not worried about sustained long-term inflation, even if the government continues to provide direct financial assistance to millions of Americans.
I hypothesize that we are unlikely to see meaningful long-term consumer price inflation, even in light of a dovish Federal Reserve and fiscal stimulus. My reasoning is as follows: technology is deflationary. Technology is deflationary primarily because it allows the production of goods and services to scale efficiently. If the production of goods can scale efficiently enough to satisfy the market's present and future demand for goods, the price of those goods should not increase even if demand increases.
As technology improves, this inflection point will be reached in more and more industries and inflation will get weaker and weaker. We have more technology today than ever before, and the pace of technological innovation is increasing, therefore deflation is more likely than inflation. Certain industries will remain susceptible to short-term supply shocks and temporary inflation spikes, but long-term inflation across the general economy is not something I am worried about, even in face of prolonged and substantial fiscal stimulus.
Technology is Deflationary
Technology is deflationary for two primary reasons. Technology reduces the demand for labor, which puts downward pressure on wages and employment levels, which in turn reduces demand for goods and services because workers have less money to spend. Technological innovation leads to automation, tools that make workers more efficient, and the elimination of some job roles. Robots replace humans in factories, Amazon's (AMZN) AWS service reduces the need for companies to hire data center engineers, and self-service checkout lanes lead to layoffs at grocery stores.
If the pool of labor stays relatively constant and the need for labor is reduced by continuing improvements in technology, it is logical to assume that wages will be suppressed over time and the buying power of the average consumer will be reduced. Wage growth hasn't been completely stagnant and there was a jump during the pandemic, but it has been close to the Fed's 2% inflation target for most of the last decade and is dropping off sharply as the economy reopens:(Source)
Korn Ferry's 2021 salary survey indicates that "more businesses are planning no raises for all employees." The survey notes that Covid-19 is the primary driver in the short term, but I expect technological improvements to put downward pressure on wages in the long term as well.
This demand-side deflationary aspect of technology is important, but can be counterbalanced by fiscal policy decisions (direct stimulus, Universal Basic Income, etc.). Many of the arguments I see for inflation acknowledge the deflationary aspect of technology but argue that inflation is still more likely due to the volume of cash being given directly to consumers and a rapidly increasing money supply. I think the demand-side deflationary aspects of automation are not being fully appreciated by the market, but I acknowledge that they can be overwhelmed by fiscal stimulus.
The second deflationary aspect of technological innovation affects the supply of goods and services. Technology is allowing more and more businesses and industries to cross an important inflection point; the point at which the production of goods and services can scale faster than the consumer demand for them. As technological improvements lower production costs and increase the speed at which goods and services can be produced, it becomes easier to satisfy the market's demand for particular goods. If the supply of goods can always meet demand, then there is no room for price increases, generally speaking. Said another way, innovation means there is more 'slack' in the production of goods and services than there appears to be on the surface.
The crux of my hypothesis is not that innovation can create a literally infinite supply of goods or services, but rather that innovation has allowed companies to satisfy the entirety of the market's present and future demand in an increasing number of industries.
Examples of Scaling
Let's look at some real-world examples. Software as a service (SaaS) companies are a good place to start. The market has correctly identified that SaaS companies should get high sales and earnings multiples in part because they can scale so efficiently and can add new customers virtually for free. If 100,000 people join Facebook tomorrow, Facebook's cost of revenue is going to be virtually unchanged. Zoom (ZM) was a perfect example at the start of the pandemic.
Thousands of companies around the world all moved to remote work in less than a month and, after ironing out some small glitches and capacity issues, Zoom was able to handle the increased demand for their product without needing to double or triple the price of their service. This is a great business model for Zoom and other teleconferencing companies, but it is also highly deflationary because the entirety of the market's sudden demand for remote conferencing tools was met nearly overnight without the need for price increases.
Similar effects can be seen in some commodity industries. The commodity industry is well known for boom and bust cycles, where the market swings from undersupply of a resource to oversupply. In times of undersupply there are sharp price spikes, followed by price collapses as the supply imbalance is corrected. If oil prices get high enough, oil producers ramp up production to meet the demand and prices come down.
If a drought in the US Midwest lowers corn production and corn prices increase, you can bet that next year there are going to be a lot more farmers planting corn to take advantage of higher prices. Technological innovations in the commodity space are making it easier for producers to close supply gaps quickly and efficiently. Fracking technology, more sophisticated methods of detecting new oil reserves, and improvements in wind and solar are all combining to lower the overall cost of energy.
Farmers are achieving record yields in crops like corn (source) and dairy farmers have moved from milking cows by hand to building robotic milking parlors that can milk dozens of cows simultaneously (source). I anticipate there will still be short-term supply and demand shocks, but I would expect them to be rarer, last for shorter periods of time, and be less severe.
As a final example, consider the entertainment industry. Streaming services have dramatically reduced the cost of media consumption and allowed new market participants to scale and compete more efficiently. With a Netflix (NFLX) account, I can watch a nearly unlimited number of movies and shows for the price of one movie theatre ticket. New music artists can produce studio-quality albums from their basements (via improved recording technology) and make their content accessible to millions of potential new fans overnight (via services like YouTube). The quality of content can vary across different platforms, but by putting the content online its consumption can scale quickly and efficiently.
There are many other examples of technology helping the supply of goods and services scale more efficiently. Things start to get really interesting when the scaling gets efficient enough that it can accommodate the entirety of consumer demand. Let's look at cheese as an example.
As mentioned above, technological improvements in the dairy industry mean that more cheese can be produced more cheaply than ever before and it is relatively easy to add additional capacity. At the same time, there is a clear upper bound to how much cheese a person can eat in a given day or year.
There are still limits to cheese production; even with robotic milking we will never be able to produce enough cheese to allow the average person to eat a million pounds of cheese a year, but the demand for cheese is never going to be that high; there is a physical limitation (not to mention a preference limitation) to how much cheese can be consumed in a given year.
The same goes for some SaaS companies and entertainment; there are only 24 in a day to consume media or participate in a Zoom call, so while production of these goods and services isn't truly infinite, demand cannot be infinite either and there are now more limitations on the demand side for these goods than on the supply side. It is hard to see a way for there to be meaningful inflation in sectors like these, as supply will always be able to meet or exceed demand, even if demand were to increase due to short-term factors or fiscal stimulus.
Short-Term Inflation Spikes and Exceptions that Prove the Rule
The more efficiently the production of a good or service can scale, the less likely it is to see meaningful price inflation. The opposite is also true. The recent pandemic provides some examples. Early on in the pandemic, especially as lockdowns were beginning, goods like Clorox (CLX) wipes, toilet paper, hand sanitizer, and masks quickly became unavailable. Most retailers chose to remain out of stock rather than charge a high enough price to keep the items on shelves (for both legal and PR reasons), but this was still clearly an example of an inflationary spike.
If you really wanted hand sanitizer you could get it, but you would have to pay 400-600% more and purchase it from resellers on Amazon (source). In practice, inflation for these types of goods spiked; the supply of the goods couldn't scale fast enough to meet the huge demand spike. That being said, less than a year after lockdowns began all of these goods are once again available to consumers at prices comparable to pre-pandemic levels (albeit thanks in part to limits on how much can be bought per customer per day).
Companies were able to ramp up production eventually; Clorox will soon be able to produce over 2 million canisters a day of disinfectant wipes, as an example (source). Was there a short-term jump in inflation? Absolutely. Will prices revert to pre-pandemic levels once production ramps up? I hypothesize yes, because companies will be able to cost-effectively meet the increased demand.
I don't mean to downplay the real and tangible pain inflicted by short-term inflation spikes. If you really needed toilet paper in April of 2020, it was difficult to find. Food prices rose for many staple items, and some items were unavailable all together. Natural disasters, terrorism, canal blockages, and other one-time events are likely to cause short-term jumps in energy prices.
Zoom (NASDAQ:ZM), Facebook (NASDAQ:FB), and Microsoft (NASDAQ:MSFT) can all handle overnight demand shocks and the nature of SaaS businesses mean supply shocks are virtually non-existent, but obviously not all industries are at that point yet and the production and delivery of physical goods might remain at risk for many more years. That being said, it took Clorox (NYSE:CLX) about 12-14 months to ramp up enough production to meet increased demand and get their disinfectant wipes back on the shelf; I am confident that it would have taken them longer to get to 2 million canisters per day in, say, the 1970s. Technology is allowing companies to ramp up faster and shortening the duration of inflationary spikes.
Other areas of the economy are experiencing prolonged periods of high inflation. The usual examples cited are housing, education, healthcare, and childcare. These sectors have high inflation because demand for these services is relatively inelastic and it is not easy to scale production of those services. Zoom can add thousands of users overnight, but building homes takes time, is labor intensive, and is constrained by physical space limitations.
Colleges and universities only have so many dorm rooms available and professors can only grade so many papers and exams. There are a relatively fixed number of doctors and physicians and a single doctor isn't yet able to care for hundreds of patients a day the way a single dairy farmer can now milk hundreds of cows a day thanks to robotic milking. Childcare is particularly difficult, because any one child is going to need a good deal of direct supervision and parents expect childcare workers to provide at least a basic level of intellectual and social stimulation.
Even in sectors where scaling is difficult today, there are technological innovations that are working to break the cycle of inflation. Finding space to build a home in a desirable location will remain a limiting factor, but advances in 3D printing technologies are dramatically reducing the cost to build homes (source). Surgical robots, automations in lab work, and improvements in Artificial Intelligence are helping doctors perform operations and diagnose conditions more quickly and accurately.
A move to online lectures and automated tools for grading exams is allowing professors to teach more students per semester. Childcare is still a tough nut to crack, but maybe giving every kid a tablet with enough engaging content on it will allow daycare facilities to accept more children in the future. Some of this is pure speculation, but as a general rule I would expect to see increasing deflationary pressure anywhere that technology is improving efficiency. It is difficult to find an industry that is immune to innovation.
I will preface this section by saying that I am not a macro-style investor, so you can take my thoughts with a grain of salt. That being said, I think there are some high level concepts that follow from a deflationary hypothesis. First and foremost, I am very comfortable holding equities and am not afraid of a dramatic rise in interest rates. Pricing power, brands, and competitive moat are going to become even more valuable.
Technological improvements might make it easy to scale the production of ketchup, but if customers are used to buying Heinz ketchup it is conceivable that Heinz will still be able to raise prices despite a general increase in the supply of ketchup. In a similar fashion, I expect companies that sell luxury goods and services to do well; most luxury brands already artificially limit the supply of their goods and have built business models around selling fewer goods for much higher prices. Finally, I am considering allocating a small portion of my portfolio to the iShares 20+ Year Treasury Bond ETF (TLT). I think the market is overly concerned about inflation and has pushed up Treasury yields as a result.
I would be looking for price appreciation on my investment when inflation fails to materialize; I'm not excited about earning just a 1.6% yield on my investment. There is the risk of short-term supply and demand shocks that might send rates higher and the ETF lower in the short term, but if one accepts the thesis that technology is going to play a disproportionate role in lowering inflation in the future then it makes sense to bet against long-term inflation.
As a final note, I find the current investment climate interesting because on the one hand the market seems to understand the transformative power of technological innovation and is applying high multiples to technology companies, while at the same time sounding the alarm about runaway inflation. More and more companies are starting to buy back their own stock (prior to the pandemic anyway), presumably because they don't have profitable reinvestment opportunities. This would seem to indicate that these companies are already able to scale efficiently enough to meet the demand for their products without needing to invest additional capital; this would be a sign that deflation is on the horizon, not inflation.
My hypothesis is that technology is deflationary. Technology is deflationary primarily because it allows the production of goods and services to scale efficiently. Long-term price inflation of a particular good or service becomes an impossibility when the production of that good or service can scale to meet 100% of current and future demand.
As technology enables more and more industries to reach that inflection point, there will be less and less price inflation across the market as a whole. Short bursts of industry-specific inflation may continue to occur, but I predict that they will be less severe and last for shorter lengths of time. I am not worried about sustained long-term inflation, even if the government continues to provide direct financial assistance to millions of Americans. I would invite readers who either agree or disagree to leave a comment below.
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