"The Fed's Megaphone": Obstacles to rate cuts in September cleared, focus on 25 basis points or 50 basis points

"The Federal Reserve's megaphone" Nick Timiraos and Wall Street Journal reporter Sam Goldfarb wrote that the CPI inflation index in July continued its trend of cooling down, with CPI stabilizing below 3% for the first time since the beginning of 2021, laying the foundation for a Fed rate cut in September.

The U.S. Department of Labor announced on Wednesday that the July CPI rose 2.9% from the same period last year, the lowest level since 2021, slightly below economists' expectations of 3%. The core inflation rate, which excludes volatile food and energy items, was 3.2%, also the lowest level in three years.

"The sustained and widespread slowdown in inflation provides the Fed with greater room to focus on any potential weaknesses in the job market." Kathy Bostjancic, Chief Economist at Nationwide, said that these data are "very encouraging... and should give the Fed confidence to start the easing process." However, the market response was muted, indicating that investors have shifted their concerns from inflation to the job market. Major stock indices edged higher, while U.S. Treasury yields retreated after an initial rise.

Wednesday's report was not perfect. The pace of home price increases was faster than in June. However, broad improvements in other areas such as used cars and healthcare were enough to offset this setback.

This data marks the third consecutive month of moderate price increases in line with the Fed's inflation target, restoring the slowdown trend that began last year but was interrupted earlier this year. After raising rates to their highest level in 20 years in July 2023, Fed officials have been watching for when to start cutting rates for a year. The possible rate cut plan in June was shelved in April due to a rebound in inflation.

But now, with improved inflation data and signs that the job market may soften in the coming months, the Fed may cut rates. The unemployment rate in July rose from 3.7% at the beginning of the year to 4.3%, reflecting lackluster hiring despite currently low layoff numbers.

Therefore, "the debate at the Fed's September meeting will focus on whether to cut rates by the traditional 25 basis points or a larger 50 basis points." Wednesday's inflation data does not resolve this debate, but it will be determined by upcoming indicators of the job market, including weekly initial jobless claims and the August employment report to be released on September 6.

Richmond Fed President Barkin said last week that officials are trying to "figure out whether the economy is slowly normalizing, allowing you to normalize rates in a stable, thoughtful way and continue to land... or whether you really need to actively address challenges now."

Some analysts believe that because the inflation rate is still above the 2% target, Fed officials may still find it difficult to cut rates by more than usual. David Berson, Chief U.S. Economist at Cumberland Advisors, said that Wednesday's data is "good enough" to justify a rate cut in September, but "good enough does not mean very good." "Inflation is declining, but it is currently only a slow decline."

The U.S. Department of Commerce will release the preferred inflation indicator of the Federal Reserve later this month - the Personal Consumption Expenditures (PCE) Price Index. Federal Reserve officials will receive this report and the CPI data for August before the meeting on September 17th to 18th. As the market currently widely expects a rate cut, the focus of the meeting will shift to whether the rate cut is a unanimous decision among officials, and how much officials expect to cut rates in the last two meetings of the year (November and December). The new economic forecasts to be released next month will provide clues about their latest thoughts.

Housing costs, or at least the way the Labor Department measures housing costs, remain a troubling issue. Since only a small fraction of leases are turned over each year, changes in market rents are lagged in inflation. Therefore, economists expect housing inflation to decline slowly, but the rate of decline will not be as slow as actually observed. Encouraging data for July, released on Wednesday, has reinforced this trend.

The preferred inflation indicator of the Federal Reserve, PCE, has dropped from a high of 7.1% two years ago to 2.5% in June this year. This decline has occurred in stages. Price increases for goods ranging from electronics to used cars first slowed down as demand for these products eased and supply chains improved after the pandemic disruption. Service sector inflation - from haircuts to car repairs, child care, and hotel stays - takes longer to ease but has also improved. This to some extent reflects a slowdown in wage growth.

Recent reports show that as consumers tighten their belts and resist the significant price increases of the past three years, pricing power of U.S. businesses is weakening. If competition between businesses intensifies, price growth may continue to slow. Based on the CPI released on Wednesday and the Producer Price Index released on Tuesday, economists expect core PCE to rise by 0.1% to 0.2% in July. This may keep the year-on-year inflation rate close to 2.6%, the same as in June