Can CPI "breathe a sigh of relief" tonight and prompt the Federal Reserve to "strike" 50 basis points in September?

The market is preparing for the Federal Reserve's first rate cut. At the Jackson Hole meeting, Federal Reserve Chairman Powell indirectly hinted at the rate cut on the early morning of September 19th, emphasizing the importance of the labor market in the current decision-making process. The mixed employment data released last week further confirmed the rate cut. However, the non-farm payroll data released last Friday also heightened concerns in the market about the extent of the expected economic slowdown, leading to negative reactions in most stock indices.

Before the Federal Reserve enters its usual "quiet period," several Federal Reserve officials made speeches last Friday, essentially confirming the open secret of the rate cut and expressing support for this first and usually most difficult rate cut decision in the interest rate cycle. However, most officials avoided publicly supporting a 50 basis point rate cut.

This week, the market's focus shifts to inflation data, with the CPI inflation report for August scheduled to be released at 8:30 p.m. Beijing time on Wednesday. Powell was very direct in his assessment of inflation at the Jackson Hole meeting. He mentioned that inflation is now closer to the Fed's target, "the upside risks to inflation have diminished." Therefore, the importance of inflation data has decreased, but this report still holds significant market influence.

Interestingly, recent inflation-related information has been mixed. The price sub-indices in the ISM services and PMI data last week brought unexpected upside surprises, indicating a potential rise in inflation. Similarly, the mid-August University of Michigan Consumer Confidence Survey showed a 1-year expected inflation rate of 2.9%.

Economists expect that the overall CPI in the U.S. will slow down from 2.9% in July to 2.6% year-on-year in August. Several economists have stated that the decline in natural gas prices and stable food prices may help control overall inflation. If the forecast holds true, year-on-year CPI inflation will hit a new low since March 2021. Core CPI inflation, excluding food and energy prices, is expected to drop to 3.2% year-on-year. These forecasts align with estimates from the Cleveland Fed's Nowcast model.

However, if we observe the performance of oil prices in August 2023 and this year, it is likely that the overall CPI will decline significantly. Oil prices rose by 2.3% monthly in August 2023, but dropped significantly by 7% in August this year. This means that inflation may decline more sharply, providing more basis for Fed doves to propose more aggressive monetary policy decisions.

Furthermore, whether CPI inflation meets economists' expectations will largely depend on the speed of rent increases. Housing costs account for two-thirds of the CPI inflation index. Many economists expect that as the slowdown in rent increases gradually shows up in official inflation data, rents will begin to exert downward pressure on inflation. However, it is worth noting that last month's data contradicted these expectations, showing that rents continue to unexpectedly rise Excluding housing factors, inflation has been hovering around the target level set by the Federal Reserve throughout the summer. The proportion of CPI sub-items with price growth exceeding 3% is now lower than the pre-pandemic average, standing at only 25%. The gradual weakening of the U.S. economy, such as a decrease in job vacancies indicating soft labor demand, a rising unemployment rate, has also strengthened people's confidence that broader inflation pressures will continue to ease. The economic downturn has not plunged the Federal Reserve into panic, but it is becoming increasingly clear that interest rates are higher than what the U.S. economy needs.

Economists at ING stated that as the non-farm payroll data failed to convince the Federal Reserve to cut interest rates by 50 basis points, the market is currently focusing on U.S. inflation data to understand the pace of Fed rate cuts, "It is clear that economic growth is losing momentum, and the market now seems to be concerned whether the economy will ultimately experience a soft landing or a hard landing."

According to CME's "FedWatch," the probability of the Federal Reserve cutting rates by 25 basis points in September is 70%, while the probability of a 50 basis point cut is 30%. If there is an unexpected decline in inflation, the expectation of a 50 basis point cut is likely to increase further. On the other hand, if the report results meet expectations, or even show a slight increase in inflation pressure, although it will not change the market's expectation for the Fed's interest rate adjustment, it may to some extent suppress the subsequent dovish rhetoric.

Charu Chanana, Head of FX Strategy at Shengbao, stated that a weaker-than-expected report may enhance market expectations of a 50 basis point rate cut, but data in line with expectations may continue to keep the debate between a 25 basis point and a 50 basis point cut unresolved, "Overall, the U.S. dollar is expected to trade sideways and rise, as the current market expectation of Fed easing still appears excessive."

Federal Reserve policymakers stated last week that they are prepared to start a series of rate cuts, noting that without a policy shift, the cooling labor market could become even more frightening. Chanana therefore believes, "This makes it likely that the Fed may choose to cut rates by 25 basis points to avoid causing panic, although they may take more aggressive rate cut measures later this year."

Other analyses suggest that the focus may still be on core CPI data, which has been stagnant for some time. If there is little price volatility but no progress, the positive risk momentum this week may subside, as traders may consider the data insufficient to convince the Fed to cut rates by 50 basis points next week.