“Oil Is The Fed’s Canary”: Is The Fed “Sleepwalking Into A Policy Mistake”?

As we and plenty of others have noted, there’s a very real risk that the Fed is about to make a policy mistake by hiking into a growing deflationary impulse.

We discussed this at length over the weekend in “Yeah, So The Fed Is Going To Hike Into A Deflationary Backdrop.” Key to that post was BofAML’s observation that “since 1957 there have been 722 overlapping two-month periods [and in] only six of these have we seen core CPI deflation – but that includes the most recent March-April period this year.”

At issue is whether the Fed should tap the brakes and wait for realized inflation to materialize rather than focusing on the (ostensibly) overheating labor market and the possibility that waiting any longer to normalize risks blowing even bigger bubbles in risk assets.

On Monday, BofAML is out with another interesting take on this, noting that the combination of dovish expectations and poor incoming data makes for a potentially dangerous setup. In short, delivering a “dovish” hike like that we got earlier this year may be well nigh impossible as expectations are already as dovish as they can conceivably get. Meanwhile, the lackluster data increases the chances of a policy mistake.

The argument is that if delivering a dovish hike is no longer possible, then the Fed could end up causing higher real rates, which might weigh on commodities (which are already facing headwinds) and that, in turn, could feed back into realized inflation and inflation expectations in a kind of double whammy scenario.

For that reason, BofAML thinks that “if the Fed hike this week triggers another leg down in commodity prices,” that will be the warning sign the they’re “sleepwalking into a policy mistake,” as the focus would quickly shift to demand conditions (as opposed to oversupply). More below…

Via BofAML

Oil is the Fed’s canary

This interest rate hiking cycle has been different…

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Gary Anderson 4 years ago Contributor's comment

The #Fed will help the #banks. They don't care about #oil or #commodities. They probably want a decline in building commodities to offset possible interest rate difficulty for housing, and the lack of workers in the housing market that drive costs up.