Reassessing the rate cut "weight" of inflation

When the non-farm employment and volatile asset prices have brought the market closer to a 50bp rate cut in September, today's inflation data may provide more of an "emotional value". The U.S. July inflation data released tonight continues to show a mild decline - core inflation remains stable, overall inflation slightly decreases, and a month-on-month growth rate of around 0.2% can indeed provide some reassurance for a rate cut in September, whether it's 25bp or 50bp. However, the data that could really "seal the deal" may be the August non-farm data released in early September. Moreover, with July as a "turning point", the weight of U.S. inflation easing in the remaining time this year will give way to employment, which may be the biggest market implication behind the release of this data.

The decline in the weight of inflation is not only due to the Fed's shift in the minutes of the July meeting, but more importantly, the dilemma of the data itself: clear cooling of goods inflation and fluctuation risks in service inflation.

Since the beginning of the year, U.S. goods inflation has made a negative contribution to the CPI on a month-on-month basis in the first half of the year. In July, the month-on-month growth rate of core goods fell to -0.3%, remaining flat at a low of -1.7% year-on-year, with the year-on-year growth rate of the sub-item of motor vehicles continuing to decline to -4.2%. The Manheim U.S. used car price index remains low and volatile, while the inventory-to-sales ratio of motor vehicle retailers continues to rise.

In the first half of this year, U.S. CPI experienced a roller coaster ride, with CPI exceeding expectations in January-March, remaining as expected in April, and falling below expectations in May-June. The core reason lies in the fluctuation of service inflation and the temporary rebound in energy prices. Housing inflation, which is sticky and has a high weight, saw its month-on-month growth rate drop to 0.2% in June, but rebounded to 0.4% in this period. The lagging effect of housing CPI growth rate may be the main risk for the inflation trend in the next six months.

Overall, the current weakening trend of US inflation remains unchanged, but it is mostly anticipated by the market. The "last mile" to return to 2% is bound to be full of obstacles due to the service industry and wages.

In a broader sense, such data differentiation and "ups and downs" are not uncommon, especially in soft data such as PMI. For example, while manufacturing data is currently weakening across the board, service sector data unexpectedly rebounded, showing overall resilience.

Whether using the Markit or ISM gauge, the July manufacturing PMI readings are at new lows for the year. Particularly, the ISM gauge's PMI production index is at its lowest point in over four years; the employment index is at its lowest level since June 2020, and excluding data from the COVID-19 period, the employment index is showing its worst performance since 2009. On the other hand, the July US service sector PMI remains above the 50 boom-bust line, and almost all sub-indices (ISM gauge) including business activity, new orders, employment, and inventories have improved compared to June.

Comparatively, the US labor market has been cooling down throughout this year, with a more certain trend of weakening employment data. Ignoring the large month-on-month drop in non-farm payrolls in July to 114,000, the unemployment rate unexpectedly rose to 4.3%, and the trend in initial jobless claims trending upwards, perhaps more trend-significant is that the supply-demand gap in the current US labor market is narrowing.

However, we still believe that the market may be overestimating the recession signals behind the employment data. In recent years, the noise in the addition of non-farm payrolls has been increasing, with limited information content—frequent revisions and often erratic movements. For example, in December 2022, there was an addition of 136,000 jobs, which sharply rebounded to 482,000 in January 2023; from March to May this year, the addition of jobs also showed a "V" shaped reversal.

The rise in the July unemployment rate to 4.3% may also be somewhat "overstated." Temporary unemployed individuals contributed to 60% of the increase in unemployment. After the impact of Hurricane "Beryl" ends, these temporarily unemployed individuals returning to work may be reflected in next month's data.

Linking weakening employment to a recession, an important point may lie in the formation of a self-accelerating negative cycle with household debt issues.

Historically, economic recessions often correspond to high leverage in the private sector. While the balance sheets of households and businesses are relatively healthy at present, as the labor market gradually weakens, the growth rates of disposable income and spending for residents will also decline For the household sector, the high interest rate environment has not transmitted to their mortgage pressure (residents locked in low-cost rates from 2020 to 2021, and have not leveraged in the high interest rate environment since 2022), resulting in lower risks for mortgage debt. However, the risk of consumer loans (especially credit cards) is more significant. The proportion of repayment expenses for consumer loans as a percentage of disposable income continues to rise, and the delinquency rate on credit cards has also exceeded pre-pandemic levels.

If the Federal Reserve does not cut interest rates, causing the high interest rate environment to persist, the pressure on household consumer loans will further increase. With the year-on-year growth rate of disposable income slowing down, household consumer spending will be suppressed, accelerating the pace of economic weakening in the United States, forming a negative cycle of labor market weakening - deterioration of private sector debt issues.

It is almost certain that the Federal Reserve will cut interest rates in September, with employment taking over the "driver's seat" from inflation.

In the coming months, it is highly probable that month-on-month inflation will remain below 0.3%, and the impact of employment data on policy and the market will become increasingly significant. If, after the impact of Hurricane "Beryl" subsides, the number of new non-farm jobs continues to decrease significantly, the unemployment rate continues to rise, and the number of layoffs turns upward, the likelihood of a 50 basis point rate cut in September will increase. Of course, this is not the baseline scenario we are currently predicting.

Article by: Pei Mingnan S1090523040004, Wu Bin, Source: Chuan Yue Global Macro, Original Title: "Reassessing the 'Weight' of Inflation Cuts"