Will Disinflation Affect The Fed’s Decision On Wednesday?

The chart below explains why inflation has been falling lately in Europe and in America. It shows the change in the year over year Bloomberg commodities index. There is a clear trend of disinflation led by oil. Wage inflation isn’t accelerating, so there’s no reason to expect any of the headline inflation numbers, whether it’s PCE or CPI, to look differently than this chart. The ECB took the ball and ran with it by putting out guidance which suggests it will extend the bond buying program when it realized inflation was waning and GDP growth was accelerating. That’s a logical step if the ECB was afraid QE would cause inflation. The 1.5% inflation rate in Europe is the same rate it was at before QE, which implies the ECB thinks there was a mega trend which reversed all its inflation creation. This is a farcical idea.

Regardless of whether the ECB is correct in its assertion about QE causing inflation, this is bullish for stocks as the ECB’s $60 billion per month bond buying program is now more likely to be extended. The Fed is making its decision on interest rates on Wednesday and will give a more detailed explanation of its balance sheet unwind. With inflation declining, the market is giving the Fed an out from raising rates and unwinding the balance sheet. The question remains if the Fed takes the ball and runs with it like the ECB did. At some point soon, the Fed will have to acknowledge the reality about inflation. If you use the word transitory liberally, any move in any market is transitory. If the Fed remains in the camp that this disinflation is transitory, it is using the word in that manner. Either at this meeting or soon after, the Fed will have to decide how to react to this change. It can either do what the ECB did or keep going with its plan to raise rates and unwind the balance sheet.

You may be wondering why the Fed would raise rates after the acknowledging inflation is falling. For a few months, inflation was at the Fed’s target, but that was only an excuse to raise rates. The reason the Fed was hawkish was because it expected wage inflation to rise due to a tight labor market, it wanted to get off the zero bound so it can cut rates in a future recession, and because the bull market in stocks allowed it to raise rates. None of those factors have changed. The labor market is the same as it was 6 months ago, the stock market is still near all-time highs, and rates are still close to the zero bound.