Whether the Federal Reserve will raise interest rates in September may be revealed tonight.
The US Bureau of Labor Statistics will release July CPI data at 8:30 AM Eastern Time on Wednesday (8:30 PM Beijing Time on Wednesday). Market expectations are for a 0.1% month-over-month rise in headline CPI and a 0.2% rise in core CPI, with annual rates falling to 3.4% and 2.5%, respectively.
Following last week's unexpectedly soft nonfarm payrolls data, this report will serve as a crucial test for September rate hike expectations. A moderate reading could further lower the probability of a September hike, while a hotter-than-expected report would increase pressure on the already hawkish-leaning Federal Reserve.
Current market pricing and the data's impact
Currently, the interest rate futures market prices the probability of a September rate hike at around 50%, essentially a coin flip. Last week's nonfarm payrolls data showed a loss of 23,000 jobs in July, which initially cooled rate hike expectations, but a subsequent rebound in oil prices pushed the probability back to even. Meanwhile, at the Fed's July meeting, three governors voted for a rate hike, and several non-voting members also clearly expressed a preference for tightening, giving hawkish voices considerable weight within the committee. Tonight's CPI data will directly influence the tilt of this balance.
A moderate reading is likely but still above target
Combining forecasts from institutions like Goldman Sachs and Pantheon Macroeconomics, this CPI report is widely expected to fall within the expected range, and is unlikely to replicate the significant volatility seen in last month's report.
Goldman Sachs expects core CPI to rise 0.19% month-over-month, with an annual rate of about 2.47%, both slightly below the consensus. Headline CPI is expected to rise only 0.05% month-over-month, with an annual rate of about 3.35%. Falling energy prices (-2.0%) are the main driver of lower headline inflation, while food prices are expected to rise modestly by 0.2%.
At the sub-component level, Goldman Sachs expects used car prices to rise 0.5% month-over-month and new car prices to rise 0.1%, but auto insurance prices to fall 0.5%. For the housing component, owners' equivalent rent (OER) is expected to rise 0.23% month-over-month, and rent to rise 0.16%, continuing the recent slowdown trend. Travel services are mixed, with airfares expected to rise 2.0% and hotel prices expected to fall 1.0%, partly due to the fading demand boost from the World Cup.
Pantheon Macroeconomics expects core goods prices to rise 0.18% month-over-month, the largest increase since last September, partly due to Apple (Apple Inc (NASDAQ: AAPL)) raising prices on most hardware products by 15% to 30% starting June 25. However, weakness in the services component will offset this. The firm expects airfares to fall 1.5% month-over-month, accommodation prices to fall 1.0%, auto insurance to continue its downward trend, and energy commodity prices to fall 2.6%, which would drag the headline CPI monthly rate by about 11 basis points.
Fed stance: Holding steady, but hawkish noise grows
RSM Chief Economist Joe Brusuelas stated that if July CPI is close to expectations, "the majority of the committee will choose to ignore supply-side shocks, and the FOMC will keep rates unchanged for the remainder of the year," providing some buffer for Fed Chair Walsh, who has faced persistent policy pressure since taking office in May.
However, the hawkish forces within the Fed are building. Cleveland Fed President Beth Hammack, one of the three governors who voted for a rate hike at the July meeting, said Monday that multiple rate hikes might be needed, emphasizing that "the impact of a single 25-basis-point adjustment on the economy is likely quite limited." Additionally, non-voting members Schmid and Musalem indicated they would have been inclined to support a rate hike at the July meeting. Although Fed Chair Walsh acknowledged that the current tightening of financial conditions is doing some of the Fed's work, and that the July employment data and its downward revision have somewhat curbed recent tightening expectations, he has not explicitly ruled out the possibility of further rate hikes.
Bank of America maintains its forecast for three rate hikes in the coming months. The bank's economists noted in a client report that the July employment report "does not change the overall picture of the labor market," and the Fed's policy reaction function remains "highly skewed towards inflation data." The bank warns that if core CPI averages 0.25% month-over-month over the next two months, "the Fed will almost certainly start raising rates in September." If the average is below 0.2%, a rate hike will be delayed. If it falls in between, September "remains a 50/50 proposition."
Both stocks and bonds under pressure, stock sentiment indicator flashes red
The JPMorgan Market Intelligence team provided a scenario analysis for this CPI report:
If core CPI month-over-month exceeds 0.30%, the S&P 500 is expected to fall 1.5% to 2.5%, with a 5% probability. If it falls in the 0.25% to 0.30% range, the index is expected to fall 0.5% to 1.25%, with a 25% probability. If it falls in the 0.20% to 0.25% range (the highest probability scenario, about 40%), the index is expected to rise 0.25% to 0.75%. If it is below 0.20%, the gain could expand to 0.5% to 2%. Overall, the bond market's reaction to an inflation surprise will be more violent than the stock market's.
Notably, the implied one-day volatility range priced by options expiring on August 12 is currently around 0.9%, slightly below the recent average of about 1.1%, suggesting the market does not expect an extreme outcome from tonight's data.
A team led by Wells Fargo analyst Ohsung Kwon is warning investors to set up hedges before the CPI release. The bank's sentiment indicator currently reads 1.4, which is in the strongest "sell" signal range since January 2018. "We see the cost of hedging as low and prefer to hedge against the risk of hot data," the analysts wrote. "If CPI surprises to the upside, the market narrative will quickly shift to stagflation concerns, especially against the backdrop of last week's weak employment data." However, Wells Fargo also noted that second-quarter corporate earnings grew 30% year-over-year, beating market expectations by 8%, the strongest growth rate in over four years, which provides some support for the stock market.
Longer-term risks: AI inflation and market structure signals
While the short-term inflation outlook is relatively moderate, Societe Generale analyst Andrew Lapthorne points out that the structure of the stock market is sending a warning signal. The bank's stock market inflation proxy index, built from developed market stocks most correlated with inflation, has significantly outperformed the MSCI World Index over the past 12 months, gaining 71%. Lapthorne stated: "The market is no longer pricing in the contradictory combination of 'strong earnings growth + rate cuts' but rather believes that such strong earnings growth typically comes with the need for rate hikes."
Meanwhile, commodities related to the AI supply chain are facing upward price pressure. It is reported that surging memory prices could push up core PCE by as much as 0.5 percentage points. Goldman Sachs expects the July core PCE monthly rate to record a relatively large 0.26% increase, partly reflecting the lagged transmission of second-quarter stock price gains to the cost of portfolio management services. A methodological adjustment for this sub-component is scheduled for the end of September, which could lead to downward revisions to the data, but a further revision in December might reintroduce a strong correlation.
More data ahead, September decision still undecided
Even if tonight's CPI result is clear, the path to a September rate hike is not set in stone. Before the September 16 FOMC meeting, the Fed will also receive the August nonfarm payrolls, August CPI, and August PPI data. The August PCE data will be released after the meeting. This means there is ample room for policy expectations to shift over the coming weeks.
Overall, the most likely scenario is that the data meets expectations, which is neither enough to reignite the flames for a September rate hike nor sufficient to completely dispel tightening expectations. The final decision on the hawk-dove debate remains in the hands of subsequent data and Chair Walsh.
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