Merrill Lynch isn’t buying the “boneless Fed” argument–or the theory that inflation is out of control. Despite a recent spate of hawkish rhetoric from the Fed, Merrill thinks the Fed is right that inflation will moderate and that it will actually cut rates by another 50 basis points by next spring. Inflation, says Merrill is a “temporary” phenomenon and the “stag” part of stagflation is the bigger worry:
The market is distracted by temporary phenomenon. The fiscal stimulus has helped to support growth in the first half of 2008 and, in combination with rising energy prices and heightened inflation expectations, this has led the market to price in a high probability of a rate hike by August. We think this is too aggressive: both the stimulus impact and the inflation impact are temporary. Growth remains well below trend implying a large, deflationary, output gap and consumers (and overall growth) remain at risk as credit remains tight and a rising unemployment rate crimps their cash-flow.
An interesting call. One point Merrill doesn’t address is the theory that most inflation is being driven by exploding commodity prices, not U.S. demand (which is already weak). Given that commodity prices continue to skyrocket, it’s hard to see how inflation will ease enough to permit more rate cuts, even with additional US weakness.