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Inflation has been cooling for several months, but markets and the economy would suffer if sharp deflation sets in.
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Deflation can eat away at company earnings and margins, which would drive stock prices lower.
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Experts told Insider that greater purchasing power could benefit consumers, but weigh on markets.
Inflation has plummeted from a blistering 9% last summer to 3% in June, and the stock market has rallied on hopes of a return to normalcy. But with prices still well above the Fed's target, policymakers have signaled more rate hikes are on the table.
That means there's a chance cooling inflation turns into outright deflation, which could eventually weigh on the labor market and stocks.
Disinflation — or the slowing pace of inflation — has continued throughout the year, with June's Consumer Price Index dropping to 3%. But on the producer side, certain data suggest deflation is around the corner, according to Kevin Gordon, a senior investment strategist at Charles Schwab. He pointed to the Producer Price Index in June dropping to 0.1%.
"It's too early to say when you may get deflation on the consumer side," he said. "A lot of people are wishing for that, so that the war on inflation can be won, but most economic downturns in history have deflation. Its a 'be careful what you wish for' scenario."
Deflation effectively comes down to how far your dollars can go. Mild deflation means consumers actually have stronger purchasing power. But Arthur Laffer Jr., president of Laffer Tengler Investments, noted that deflation stemming from a collapse in demand or high unemployment presents a much worse scenario.
"With mild deflation, consumers can buy more than before," Laffer said. "But if it's bad deflation, and people can't buy stuff because they're out of work, prices fall because demand is destroyed."
Main Street vs. Wall Street
Since most people look to headline CPI for a reading on inflation, many have wondered why the Fed plans to raise interest rates again, given that it's fallen more than expected in recent months and the central bank has hiked rates 10 times since March of 2022.
But Wall Street and policymakers, Gordon explained, are primarily targeting core personal consumption expenditures, which excludes food and energy prices. That provides insight into the stickiest parts of inflation.
"The numbers the Fed is looking at aren't anywhere close to deflation," the Schwab strategist said. "There's a disconnect between Main Street and Wall Street, but the Fed has made it clear that the risks of inflation coming back again outweigh the risk of a slower economy, and they definitely don't want inflation expectations to get embedded."