Product prices are as per Walmart.
Courtesy: Walmart
Tuesday's news was good for inflation, and investors will be hoping things will improve further on Wednesday when the Labor Department releases its July CPI report.
With the result down one point, confirming that the jump in prices at the start of the year was either a fluke or the last gasp of inflation, a positive CPI reading could mean the Fed is able to turn its attention to other economic challenges, such as a slowing labor market.
“At this point, the inflationary pressures we saw have largely dissipated,” said Jim Bird, chief investment officer at financial advisory firm Plante Moran. “Inflation is no longer of any importance at this point. There is a widespread expectation that the worst is over.”
Like others on Wall Street, Baird expects the Fed in September to shift its focus from a hawkish policy to a somewhat more dovish stance to avoid a potential weakness in the jobs picture.
While consumers and businesses continue to express concern about rising prices, the trend has already changed. Tuesday’s Producer Price Index report for July helped confirm optimism that the high inflation numbers that began in 2021 and rose again in early 2024 are in the rearview mirror.
The producer price index, seen as a measure of wholesale inflation, showed prices rose just 0.2% in July and about 2.2% from a year earlier. That’s now very close to the Fed’s 2% target and suggests the market’s impetus for the central bank to start cutting interest rates is on track.
Economists polled by Dow Jones expect the CPI to show a 0.2% increase on both the all-item reading and the core measure, which excludes food and energy. Still, that’s forecast to show rates of 3% and 3.2%, respectively, over 12 months — well below the mid-2022 highs but still far from the Fed’s 2% target.
But investors are waiting for the Fed to start cutting interest rates at its September meeting, given weak inflation and a weak labor market. The unemployment rate is now 4.3%, up 0.8 percentage points from a year ago, triggering a recession flag known as the “contribution rule.”
“Given the focus on the relative weakness in the labor market, and given the fact that inflation is coming down very quickly, and I expect that to continue over the next few months, it would be surprising if the Fed did not start moving toward easing very quickly, perhaps at the September meeting. If it does not do so at the September meeting, the market will not accept that,” Baird said.
Concerns about slow Fed response
A brief spike in initial weekly jobless claims, along with other weak economic metrics, has some market investors looking briefly at an emergency interest rate cut.
Although that sentiment has dissipated, there is still concern that the Fed is slow to ease monetary policy, just as it was slow to tighten monetary policy when inflation began to rise.
Another benign inflation report “makes the Fed feel quite comfortable that they can shift their focus away from inflation and toward employment,” said Tom Porcelli, chief U.S. economist at PGIM Fixed Income. “They could have shifted their focus away from inflation and toward employment … months ago. There are cracks forming in the labor market backbone.”
With the dual reality of low inflation and high unemployment, markets are almost certainly pricing in a rate cut at the Fed’s Sept. 17-18 meeting, the only question remaining is how much. Futures are roughly split between a quarter- or half-percentage-point cut, and are largely leaning toward a full percentage-point cut by year-end, according to CME Group calculations.
But futures prices have been off target for most of the year. Traders started the year expecting a rapid pace of cuts, then eased back to expecting just one or two cuts before the recent shift in the other direction.
“I’m as interested in Wednesday’s inflation report as anyone else, but I think it would take a real exception for the Fed to change its tone from 1) shifting to employment as its focus, and 2) seriously considering cutting rates in September,” Porcelli said. “They should start strong. I can easily make the case for the Fed to cut rates by just 50 basis points to get things started because I think they should have cut rates already. I don’t think they’re going to do that. They’re going to start modestly.”
