Wednesday’s CPI report could signal a change in Fed thinking

Tuesday’s news was good for inflation, and investors are hoping for an even better reading on Wednesday, when the Labor Department releases its Consumer Price Index for July.

With the score dropping by one spot, confirming that the spike in prices earlier in the year was either a fluke or a last gasp for inflation, the positive CPI reading could mean the Fed can turn its attention to other economic challenges, such as a slowing labor market.

“At this point, the inflationary pressures that were building have largely dissipated,” said Jim Baird, chief investment officer at Plante Moran Financial Advisors. “Inflation is pretty much a non-issue at this point. There’s a widespread belief that the worst is easily behind us.”

Like others on Wall Street, Baird expects the Fed to shift its focus in September from tightening policy to fight inflation to a slightly looser stance to prevent a deterioration in the employment situation.

While consumers and business executives continue to express concern about rising prices, trends are certainly shifting. The Producer Price Index (PPI) report for July released on Tuesday reinforced optimism that the uptick in inflation numbers that began in 2021 and will spike again in early 2024 is behind us.

The PPI report, a measure of wholesale price inflation, showed inflation rose just 0.2% in July, or about 2.2% year-on-year, very close to the Fed’s 2% target, suggesting that market impulses that the central bank should start cutting interest rates are largely on track.

Economists surveyed by Dow Jones expect the CPI to rise by a similar 0.2% for both the all-item index and the core index excluding food and energy. But the 12-month gains are expected to be 3% and 3.2%, respectively — well below the mid-2022 highs but still quite far from the Fed’s 2% target.

Still, investors are hoping the Fed will start cutting rates when it meets in September, given that inflation is weakening and the labor market is also weakening. The unemployment rate has now risen to 4.3%, up 0.8 percentage points over the past year and triggering a long-proven recession warning sign known as the thumb rule.

“Given all the attention on the relative weakness of the labor market, given that inflation has fallen pretty rapidly and we expect that to continue over the next few months, I would be surprised if the Fed doesn’t start moving quickly to ease policy, perhaps at its September meeting,” Baird said. “If they don’t do that at their September meeting, the market is not going to take kindly to that.”

There was a brief surge in the market hoping for an emergency rate cut as weekly new unemployment insurance claims rose and other economic indicators weakened.

Those sentiments have dissipated, but worries remain that the Fed may be slow to ease monetary policy, just as it was slow to tighten when inflation began to accelerate.

Another mild inflation report makes the “Fed feel totally comfortable shifting its focus from inflation to labor,” said Tom Porcelli, chief U.S. economist at PGIM Fixed Income. “They could have shifted their focus from inflation to labor months ago. There are cracks in the labor market backdrop.”

With the twin realities of falling inflation and rising unemployment, markets have priced in a rate cut at the Fed’s Sept. 17-18 meeting as an absolute certainty, with the only question remaining being the size of the cut. Futures prices are heavily leaning toward a 0.25% to 0.5% cut and even a 1% cut by the end of the year, according to CME Group calculations.

But futures prices have been way off for much of this year, with traders expecting rapid rate cuts early in the year and then just one or two cuts before swinging in the opposite direction recently.

“I [Wednesday’s] “I’m as interested in the inflation report as anyone, but I think it would take something extremely extraordinary for the Fed to change its stance from 1) shifting its focus to labor and 2) seriously considering cutting rates in September,” Porcelli said. “The Fed should start cutting rates aggressively. You could easily make the argument they should start with a 50 basis point cut, since they’ve probably already started cutting rates. I don’t think they’ll do that. I think they’ll start conservatively.”