Following the unexpectedly weak July employment report released on Friday, market expectations for a Federal Reserve rate hike in September have cooled, making upcoming inflation data a potential key factor in determining policy direction. Economists anticipate that U.S. core CPI will slow to a five-year low, further weakening the case for hawkish policymakers who argue for continued tightening.
In their latest weekly outlook report, economists noted that while the July employment report dampened bets on a September rate hike, the option to raise rates has not been completely removed from the table. Currently, there remains a clear divergence of views within the Fed and among market participants. One camp argues that the central bank needs to reaffirm its commitment to fighting inflation through a rate hike, particularly as the Chair seeks to maintain credibility on inflation. The other camp contends that price pressures are easing, and the Fed's current policy path is the correct one.
The economic team expects upcoming July CPI and PPI data to support the latter view, projecting that the Fed will likely keep interest rates unchanged at its September meeting.
Core CPI May Post Lowest Annual Increase Since March 2021
The July CPI report, due next Wednesday, is expected to become a focal point for markets.
The team forecasts that headline CPI will rise 2.4% year-over-year in July, with the pace further slowing to between 2.2% and 2.3% in the following two months. They note that historically, this pattern often corresponds with core CPI slowing to 2%, which would be the lowest reading since March 2021.
The team points out that core PCE inflation nearing the Fed's 2% target suggests the current disinflation trend may be approaching the policy goal once again. If these projections materialize, they would challenge the recent arguments from some Fed hawks that U.S. inflation has been persistently above the 2% target, requiring more aggressive action from the central bank.
The team also expects month-over-month CPI to be flat in July, with core CPI rising 0.1%.
Divergent Inflation Indicators Keep the Fed Cautious
However, the economic team also cautions that the Fed cannot ignore the significant divergence among different inflation indicators. While core CPI is expected to continue cooling, core PCE inflation remains above 3%. The team believes such a pronounced deviation between core CPI and core PCE is unusual and cannot be simply dismissed.
This point actually supports the Chair's previously stated view that the Fed needs to observe a broader range of economic indicators rather than relying on a single inflation measure to determine policy direction. Therefore, even if July CPI shows further cooling, hawkish members within the Fed may still argue that more evidence is needed to confirm that inflation is steadily declining.
Housing Market Cooling Also Reduces Inflation Upside Risk
Beyond inflation data, the economic team is also monitoring trends in the U.S. housing market. The report notes that elevated mortgage rates continue to suppress housing activity. The sharp weakening in June pending home sales suggests that existing home sales may remain soft in July. The team forecasts that July existing home sales will be approximately 4.01 million units on an annualized basis, a decline of 2% month-over-month.
Economists believe that weak demand and improving supply are driving a rebalancing in the housing market, which helps alleviate future pressure on home prices rather than creating new inflation risks. Since housing costs have long been a significant component of U.S. inflation, the housing market cooling could also contribute to further disinflation.
Fed Expected to Hold Steady in September
Synthesizing signals from employment, inflation, and the housing market, the economic team expects the Fed to maintain its current interest rate at the September FOMC meeting. They believe upcoming CPI and PPI data could further support the "wait-and-see" policy stance.
In addition to inflation data, the market will also focus on the following U.S. economic data releases in the coming week:
Initial jobless claims for the week ending August 8, released on Thursday;
July PPI, released on Thursday;
July retail sales, released on Friday;
The University of Michigan's preliminary August consumer sentiment index, released on Friday.
These data points will help the Fed assess whether economic momentum is weakening further.
September Policy Focus Shifts to Inflation as Fed Awaits More Evidence
Following the July employment report, the core question for the Fed's September meeting has shifted from "whether a rate hike is needed" to "whether a rate hike is still necessary." A cooling labor market and slower wage growth provide more reasons to keep rates unchanged, but core PCE remaining above 3% and concerns from some officials about inflation credibility mean the possibility of a rate hike has not entirely disappeared.
As the economic team points out, if future CPI continues to decline, the rationale for the Fed to maintain its current policy path will strengthen further. However, if inflation rebounds, the hawkish camp could regain the initiative. Therefore, ahead of the September FOMC meeting, the market's focus will shift from employment to inflation: whether the July CPI can prove that U.S. price pressures are steadily declining will be the key evidence determining the Fed's next move.
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