Yeah, So The Fed Is Going To Hike Into A Deflationary Backdrop

Right, so the Fed is either going to:

1. hike to stave off runaway inflation that they assume may eventually materialize if an economy running at full employment is allowed to overheat
2. hike into an environment characterized by still lackluster realized inflation and thereby increase the chances that we plunge right back into a deflationary death spiral

No one really knows which.

As noted on Saturday, it’s a “who you gonna believe” thing – the labor market or inflation?

It’s possible that at this point the concern has shifted to bubble fighting. That is, it could very well be that the committee is going to jump on the opportunity to squeeze in another hike while financial conditions are favorable (weak dollar and record high stock prices). They can worry about who’s right between the labor market and inflation once they get in another hike and thereby partially inoculate themselves against criticism they didn’t do anything to try and curb excessive speculation in out-of-control financial assets.

Whatever the case, they are running the risk of tightening just as the deflationary impulse seems to be gathering steam. That’s the topic of a new BofAML piece appropriately entitled “Deflation And Rate Hike”:

And while the following doesn’t make for the most exciting reading, it’s definitely something that’s worth the three minutes it will take you to skim it.

If nothing else, this commentary should be recorded for posterity..

Via BofAML

Deflation and rate hike

Since 1957 there have been 722 overlapping two-month periods. As core CPI prices almost always go up (Figure 1), in only six of these, or less than 1%, have we seen core CPI deflation — but that includes the most recent March-April period this year (Figure 2).

On Wednesday we get the most recent (May) reading on core CPI as well as the Fed’s rate decision. With the Fed widely expected to hike, and normally not inclined to surprise investors, a rate hike is the baseline. But the inflation data has to be concerning, especially as long term inflation expectations have now completely retraced their post-election increase (Figure 3).

Moreover, as we have consistently pointed out this year, other data is week and suggest everybody is in wait-and-see-mode, including C&I and consumer lending data.

So the Fed has to be very careful in crafting the statement message and press conference.