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Tuesday's news was good for inflation and investors are hoping things will get even better on Wednesday when the Labor Department releases the consumer price index report for July.
With the reading down one point, further confirming that the price increase earlier this year was either a fluke or the last gasp of inflation, a positive CPI could mean that the Fed can turn its attention to other economic challenges, such as the slowing labor market.
“The inflationary pressures we had built up have now eased significantly,” said Jim Baird, chief investor at Plante Moran Financial Advisors. “Inflation is almost a non-issue at the moment. There is a general expectation that the worst is behind us.”
Like others on Wall Street, Baird expects the Fed to shift its focus in September from a tight monetary policy to combat inflation to a somewhat looser stance to prevent a possible deterioration in the employment situation.
While consumers and business owners remain concerned about high prices, the trend has actually changed. The Producer Price Index (PPI) report for July, released on Tuesday, confirmed optimism that the elevated inflation figures that began in 2021 and rose again in early 2024 are behind us.
The PPI report, considered a gauge of wholesale inflation, showed that prices rose just 0.2 percent in July and about 2.2 percent from a year earlier. That figure is now very close to the Fed's 2 percent target and suggests that the market's impulse to push the central bank to cut interest rates is arriving at about the right time.
Economists surveyed by Dow Jones expect the consumer price index (CPI) to rise 0.2 percent for both all items and the core index excluding food and energy. However, the 12-month rates are expected to be 3 percent and 3.2 percent, respectively – well below their mid-2022 peaks, but still far from the Fed's 2 percent target.
Still, investors expect the Fed to start cutting rates at its September meeting as inflation and the labor market ease. The unemployment rate has now risen to 4.3%, a 0.8 percentage point increase from a year ago that has triggered a time-tested recession signal known as the Sahm rule.
“Given the focus on the relative weakening of the labor market and the fact that inflation is coming down quite rapidly and I expect that to continue over the next few months, it would be a surprise if the Fed did not start easing very quickly, presumably at the September meeting,” Baird said. “If they don't do that at the September meeting, the market is not going to take that well.”
Concerns about slow Fed response
A brief increase in weekly initial jobless claims and other weakening economic indicators briefly led some market participants to hope for an emergency cut in interest rates.
While that sentiment has dissipated, concerns remain that the Fed may be reluctant to ease monetary policy – just as it was reluctant to tighten monetary policy when inflation began to rise.
Another favorable inflation report “gives the Fed some reassurance that it can shift its focus from inflation to the labor market,” said Tom Porcelli, chief U.S. economist at PGIM Fixed Income. “They could have shifted their attention from inflation to the labor market months ago. Cracks are forming in the labor market backdrop.”
With inflation falling and unemployment rising, markets are absolutely pricing in a rate cut at the Fed meeting on September 17-18. The only question is by how much. Futures prices fluctuate between a quarter or half a percentage point cut, according to CME Group calculations, and are strongly leaning toward a full percentage point cut by year-end.
However, futures prices have been way off the mark for most of the year. Traders started the year expecting a quick rate cut, but then went on to expect only one or two more rate cuts before the recent swing in the other direction.
“I am just as curious about [Wednesday’s] Inflation report like any other, but I think it would take a real outlier to get the Fed to 1) shift the focus to labor and 2) start thinking seriously about cuts in September,” Porcelli said. “They should start aggressively. I can easily make a case for the Fed cutting rates 50 basis points just to get started because I think they should have started cutting already. I don't think they're going to do that. They're going to start modestly.”
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