The Big Picture
The inflation data could be better, but it is not lost on the market that it has been a lot worse and continues to improve. That is true no matter the inflation gauge.
The Producer Price Index (PPI), the Consumer Price Index (CPI), and the PCE Price Index are all in a state of disinflation. None, however, are at the Federal Reserve's 2% inflation goal, but all are tracking in that direction, some a little more slowly than others.
Importantly, the Fed's preferred inflation gauge -- the PCE Price Index -- is closer to the 2% goal than the CPI is. That makes sense given that the shelter component has a lower weighting in the PCE Price Index than it does in the CPI; also, the PCE Price Index captures the substitution effect, which accounts for consumers trading down to less expensive items, whereas the CPI is tabulated based on a fixed basket of goods and services.
There is often about a half percentage point difference between the two consumer inflation readings because of those nuances, and that half a percentage point is apt to go a long way in the Fed's decision to cut the target range for the fed funds rate at the September FOMC meeting.
A Good Look
Although the Fed's inflation goal is 2%, hitting it is not a precondition for cutting rates. Fed Chair Powell has clarified that the committee needs to be confident that inflation is on a sustainable path toward reaching the 2% goal. The charts of the PCE and core PCE Price Indexes are exhibiting favorable trendlines to that end.
The PCE Price Index was up 2.5% year-over-year in June and the core PCE Price Index was up 2.6%. In June 2022 they were up 7.1% and 5.2%, respectively.
The Fed's Summary of Economic Projections in June showed a median estimate of 2.6% for PCE inflation and 2.8% for core PCE inflation in 2024 with the range of estimates between 2.5-3.0% for PCE inflation and 2.7-3.2% for core PCE inflation.
Right now, then, it is a good look for the inflation readings and the prospect of an impending rate cut. We suspect Fed Chair Powell will intimate as much in his August 23 speech on the Economic Outlook at the 2024 Jackson Hole Economic Policy Symposium.
The market is going to be expecting as much, too. If he does not, the market will be deflated.
A Second Chance
Currently, there is a 100% probability of a 25-basis points rate cut priced into the fed funds futures market, according to the CME FedWatch Tool. That includes a 23.5% probability of a 50-basis points rate cut in September, which is down sharply from the 55.0% probability seen on August 8.
Expectations for a larger rate cut got dialed back with the arrival of some pleasing initial jobless claims data, a retail sales report for July that was much stronger than expected, and Walmart's (WMT) contention that it has not seen any additional fraying of consumer health. Walmart said that after reporting a robust 4.2% increase in U.S. comparable sales, excluding fuel, for its fiscal second quarter ending in July.
The confluence of these happenings silenced the hard-landing fears that arose with the weaker-than-expected ISM Manufacturing and Employment Situation reports for July, and breathed life back into the soft-landing scenario.
What the market does with this second chance of a soft-landing life remains to be seen, but it will be resting on future economic releases and the Fed's policy decision in September.
A Debatable Point
The Fed has held the target range for the fed funds rate steady at 5.25-5.50% since July 2023. With the improvement in inflation in the interim, there has been a jump in real rates that has started to create some jump scares about the fed funds rate being overly restrictive.
That concern is rooted in the lag effect, whereby it takes many months for a single rate cut (or hike) to have an effect on economic conditions. The concern is that the lag effect of prior rate hikes is starting to hit home with a weakening labor market. Participants, therefore, have become increasingly worried that the Fed is sticking too long with its current policy rate and will be forced to react to a weak economy as opposed to taking a proactive step of cutting rates to forestall a weak economy.
This is a debatable point with an economy still projected to increase 2.0% in the third quarter, according to the Atlanta Fed's GDP Now model estimate, and the unemployment rate sitting at a relatively low 4.3%. Employment, however, is a lagging indicator, which is what has some participants worried. Then again, initial jobless claims are a leading indicator, and they continue to run well below levels typically associated with a recession.
See, we told you it is debatable as to whether the Fed is making (or has already made) a policy mistake. This is why there is a lot of hand-wringing around every economic release, because participants are handicapping what each release could mean for monetary policy.
What It All Means
Fed officials have been paying more lip service to the idea that a decision to cut rates is drawing near. The market has its mind made up that this decision will be made at the September FOMC meeting.
The market has had its mind made up before, of course, only to be proven wrong by its rate cut projections. This time feels different.
- It feels different because Fed officials are at least talking about the idea of cutting rates soon.
- It feels different because there is a legitimate case to be made that the fed funds rate is overly restrictive for where inflation is.
- It feels different because -- the July Retail Sales Report notwithstanding -- there have been a lot of anecdotal reports about consumer spending pressures.
- It feels different because the PCE inflation readings have a 2-handle on them, and each is steadily moving closer to the Fed's 2% inflation goal.
The economy is still growing, inflation is coming back toward the Fed's 2% goal, and the labor market has softened. That is a good sketch of a soft-landing environment, and it is why it has become more of a soft sell for the Fed to cut rates than it was at the start of the year.
We expect the Fed this time to buy what the market is selling.
