Forget Hyperinflation: Cathie Wood Says It’s Time to Worry About Deflation

With the price of goods from food to energy on the rise, it’s hard to go anywhere (except the Fed building) without hearing about runaway inflation. Cathie Wood is not one of those investors. 

The famous founder, CEO, and CIO of ARK ETFs has established herself as a thought leader at the forefront of the innovation economy.

How it started: Twitter and Square CEO Jack Dorsey took to Twitter to proclaim that “Hyperinflation is going to change everything.”

In 2008-09, when the Fed started quantitative easing, I thought that inflation would take off. I was wrong. Instead, velocity – the rate at which money turns over per year – declined, taking away its inflationary sting. Velocity still is falling. https://t.co/tFaXSaCKqS

— Cathie Wood (@CathieDWood) October 25, 2021

Finance Twitter (aka FinTwit) took hold and nearly universally panned the tweet, while Cathie Wood gave her own very different take.

In a twelve-part argument, Cathie said that we need to worry about deflation (a decline in the price of goods and services) not inflation. Here’s why.

Inflation is more than just the supply of money

In Wood’s view, many people mistakenly think about inflation in terms of money supply. They believe if the supply of money increases, then it must lead to inflation.

Instead, Wood has a much more formulaic view of what causes inflation. It’s not simply the supply of money, but also how the supply impacts the velocity of money.

Velocity refers to the rate at which money changes hands. Higher velocity is an inflationary force — meaning if money is moving around faster, it often leads to a rise in price.

Think about it this way: If there is $100 in the system and you see $5 a month come through your hands, then you have one view of money. If, however, people spend their money more quickly and you see $5 come through your hands every two weeks, then you have a very different view of money. There still may be $100 in the system, but since velocity increased, your willingness to spend the $5 increased as well. The increased willingness to spend increases the price at which consumers are willing to pay for goods. It’s a feedback loop that results in higher prices across the board.

When the Fed began quantitative easing in 2008, many investors and economists (including Wood herself) believed the new policy would lead to inflation if only for the sheer amount of money being pumped into the system. However, she didn’t account for the importance of the velocity of money.

“I was wrong”, admitted Cathie. “Instead, velocity declined, taking away its inflationary sting,” Just like 2008, the velocity of money is currently trending lower. Businesses and consumers are holding onto their cash as they search for a better deal, hoping to be rewarded with lower prices in the near future.

Innovation drives deflation

Wood didn’t stop there. Her second point calls technological innovation, such as artificial intelligence, the most “potent” deflationary force.

We all have examples in our personal lives. The plasma TVs that were so expensive when they first came out are now able to be purchased at a fraction of the cost.

Now, not only have costs declined, but the quality of products has increased as well.

For instance, the cost of training artificial intelligence has been declining at an annual rate of 40% to 70%. In Cathie’s view, artificial intelligence “is likely to transform every sector, industry, and company during the next five to 10 years.” Declining costs will ultimately result in lower prices throughout the AI landscape.

Creative destruction

With pervasive technology like artificial intelligence becoming dramatically cheaper to produce, companies that aren’t spending enough money on innovation will be punished as they fall behind and race to catch up.

Rather than allocating capital towards long-term growth, Wood argues that most industry leaders are overspending (and overborrowing) for shareholder-oriented actions like dividends and buybacks. As innovation takes hold, those companies will have to pay off that debt “by selling increasingly obsolete goods”, likely at a discounted rate.

Essentially, Cathie believes companies are borrowing from tomorrow’s growth potential to keep today’s shareholders happy. They could be making a critical error by prioritizing short-term gratification over innovating for long-term growth.

Cyclical factors impacting deflation

The themes of increased demand and reduced supply caught businesses off guard during the pandemic.

Imagine you’re in charge of ordering inventory for a retail business ahead of the holiday season. It’s not just any holiday season, either. People have been cooped up. Consumers have been saving their money at record levels, and with the economy re-opening, it’s time to spend.

You would have already been ordering an increased supply of the goods you sell in preparation for any holiday season, but now you have to compete with a new foe: A clogged supply chain.

In our post-pandemic world, goods are less plentiful and take longer to arrive. That means getting them is no small task. So, what would you do? Likely, you would do what most businesses are doing ahead of the holiday season: paying up ahead of time for bulk shipments of the products they think they can sell over the holidays. Better to have too many than not enough, right? Maybe not.

The race to stay stocked has companies ordering more products than they will actually sell. After the holidays pass and the dust settles, those businesses will be left with a lot of inventory. It can actually be a burden to store too much inventory, particularly when that inventory is aging all the time, becoming less and less sought after with each passing day.

So what will companies do after the holidays? What do companies always do when they need to make space for new products? They will have to let go of that inventory at a discount.

With the reintroduction of discounts comes competition. Suddenly, competing businesses are forced to lower their prices as well to maintain the appeal of their products. As the cause and effect relationship plays out, the result is a cascading wave of deflated prices.

The rise and fall of commodities

Dramatic rise and fall in commodities like lumber and iron ore bolster the deflationary argument. Prices rose to a point that consumers were no longer willing to pay, and equilibrium was quickly established. This has been the course of events for most commodities.

Strikingly, oil has not followed that trend. Although if you were to ask Cathie Wood, she would likely say that oil has not followed the trend, yet. She makes the point that the “near quadrupling of oil prices since the low last year” is because of “supply-side” support in the form of ESG mandates, reduced production, and increased spending on renewable energy.

Despite strength on the supply side, oil demand has fallen below the levels seen in 2019. Driving the downtrend in demand is an uptick in the cultural acceptance and use of electric vehicles, a trend that Cathie believes will continue to drive oil prices lower in the long term.

The bottom line

A downtrend in velocity foreshadows consumers who are starting to question if holding onto their money will get them a better price in the future. Simultaneously, businesses are anticipating large demand for the upcoming holiday season. They’re spending more money on building up inventory instead of improving the products within that inventory.

Cathie Wood argues that as inventories begin to age, their products will become outdated — rendered obsolete by businesses who have spent their money on the future, rather than the present.

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