Traders expect the Federal Reserve to cut interest rates significantly, facing the risk of underestimated inflation

The Producer Price Index (PPI) for July, released on Tuesday, showed a lower-than-expected increase, easing concerns about inflation for many market participants and reinforcing traders' expectations of multiple rate cuts by the Federal Reserve before mid-2025.

According to information from the Wise Finance app, based on the Federal Reserve observation tool from the Chicago Mercantile Exchange (CME), federal funds futures traders are increasingly inclined to believe that by next July, interest rates could drop by a full two percentage points. This would bring the Fed's main interest rate target down from the current 5.25% to 5.5% to around 3.25% to 3.5%. This expectation also takes into account a 54.5% chance of a larger-than-normal half-percentage point rate cut in the Fed's next policy statement on September 18, as well as further easing measures that may be taken before the end of the year.

In other words, traders have returned to their early-year expectations of multiple rate cuts, this time based on concerns about economic slowdown or recession rather than inflation pressure. The issue is that multiple rate cuts imply that policymakers believe they will not trigger inflation again.

The PPI report released on Tuesday showed a mere 0.1% increase in producer prices for July. In response, economist Stephen Stanley cautioned that the data included some peculiar and unstable factors, while Paul Ashworth stated that the report "is not as good as it looks." Lauren Henderson, an economist at Stifel, Nicolaus & Co. in Chicago, pointed out that the details of the report are "uneven." Additionally, Federal Reserve Governor Michelle Bowman expressed caution about rate cuts over the weekend, stating that she still sees upward risks to inflation.

Despite signs of easing inflation pressure in the PPI report, Henderson mentioned that she and her company are still waiting for more data. "Contrary to the market's general view, our basic expectation is that the Fed will stand pat in September until we see Wednesday's CPI data and end-of-month PCE data," Henderson said over the phone. "We are more inclined to Bowman's view, believing that the risks are to the upside and expecting the first rate cut to possibly wait until the fourth quarter."

The Consumer Price Index (CPI) for July will be released on Wednesday, with the annual inflation rate expected to remain at 3%, while the 12-month core inflation rate is projected to slightly decrease to 3.2%. The Federal Reserve's annual Jackson Hole Symposium will take place from next Thursday to next Saturday, providing Powell with an opportunity to share his latest views before more data is released.

The July data for the Fed's preferred inflation gauge, the Personal Consumption Expenditures (PCE) Index, will be published on August 30, followed by the August CPI report on September 11, just a week before the Fed may make its first rate cut of this cycle.

"We still have some concerns because inflation data exceeded expectations for three consecutive months in the first quarter," Henderson said. "The Fed does not have a great track record in achieving a soft landing, having succeeded only once in the mid-1990s. Based on past cycles, the Fed will face significant challenges in striking a delicate balance between reducing inflation and maintaining economic stability." However, 'this cycle is very different from the past, and we do not rule out the possibility that the Federal Reserve can overcome inflation while cutting interest rates.'

Wednesday's CPI report and the August data released in September are crucial because traders are convinced that the Federal Reserve will begin easing policy next month. Their only concern is whether the Federal Reserve will cut interest rates by the usual 25 basis points or by a larger magnitude. According to economists surveyed by foreign media, the annual inflation rate and core inflation rate in the July CPI report are expected to exceed the Federal Reserve's 2% target.

Derek Tang, an economist at Monetary Policy Analytics (founded by former Federal Reserve Governor Larry Meyer), pointed out that the issue facing the Federal Reserve and financial market participants now is, 'Do you believe that inflation will continue to decline? If so, then cutting interest rates will not come at a cost and can provide insurance against a recession.'

'If inflation remains stagnant, the Federal Reserve can still slow down the pace of rate cuts, which is not a bad outcome,' Tang said over the phone. 'The real problem is if inflation rises again, the Federal Reserve will make a mistake by cutting rates. This will become tricky because simply slowing down the rate cuts may not be enough to address it.'

Rate cuts seem to be a price that Federal Reserve officials are willing to pay now, 'if it means there is a chance to save economic expansion and avoid a recession,' he said. 'Nevertheless, there may be more supply shocks from domestic and foreign sources in the future. This means that inflation will become more volatile, and Federal Reserve officials will need to ask themselves whether they can really achieve the 2% target, or whether they should allow some fluctuations around this level.'

The first half of this year has shown that even without actual actions by the Federal Reserve, the mere expectation of rate cuts can have an impact: the stock market's rise in May is believed to have led to a so-called wealth effect, making many Americans feel wealthier, thus making it more difficult to suppress consumer demand to curb inflation.

Although the CPI remained flat in May and provided many positive news about inflation, the Federal Reserve has been cautious in avoiding rapid rate cuts for several months, stating that they need more confidence in the data before taking action.

Glenmede, headquartered in Philadelphia with $45.5 billion in assets, Vice President of Investment Strategy Michael Reynolds said, 'We believe the Federal Reserve is very concerned about the risks of cutting rates too quickly. The reason they have been waiting is that they will receive two CPI inflation data before the September meeting. If they see signs of improvement in inflation, policymakers will have room to start cutting rates.'

'We believe that the Federal Reserve gradually and cautiously returning to a neutral interest rate level is a sustainable path,' Reynolds said. 'Our basic expectation is that the economy will not fall into a recession, but we must closely monitor labor market data, as the situation may change rapidly.'

On Tuesday, U.S. Treasury yields hit their lowest level since August 5, with the 2-year yield, sensitive to the direction of Federal Reserve policy, falling by 7.2 basis points to 3.943%. The three major U.S. stock indexes closed higher