With the Federal Reserve's next meeting just days away, the market has been pouring over any relevant economic data to look for clues on the current state of inflation and the economy as the Fed gears up to cut interest rates for the first time since early 2020. The August jobs report sent the market reeling last Friday after it showed the U.S. economy added fewer jobs than expected. Last week, the S&P 500 posted its most severe week of losses since March of 2023.
But that already feels like a lifetime ago after the U.S. Bureau of Labor Statistics recently released the August reading of the Consumer Price Index for All Urban Consumers. The market just got its next hint on inflation. Here's why it's important and what it means for the Fed.
The Fed is likely to cut rates, but by how much?
Data in recent months has indicated that the economy is cooling and inflation is slowing. U.S. non-farm payrolls added 142,000 jobs in August, 19,000 below consensus. Unemployment ticked down marginally to 4.2%. Meanwhile, Fed Chairman Jerome Powell all but indicated that the Fed will begin cutting interest rates at its upcoming meeting, saying at the Fed's August Summit in Jackson Hole that "the time has come for policy to adjust."
The big question is how much will the Fed lower the federal funds rate , which currently hovers in the range of 5.25%-5.50%. In one camp, investors believe the economy is still holding up reasonably well while consumer prices have come back down after surging last year. This camp believes the Fed can engineer a soft landing and therefore only needs to do a quarter-point cut at its meeting.
In another camp, investors believe that the Fed's aggressive rate-hiking campaign over the last two years, which has included numerous 75-basis-point rate hikes, has likely gone too far and will soon lead to rapid deterioration in the economy and some kind of moderate to severe recession. This camp is more in favor of a half-point hike to make sure the economy doesn't slow too much when the real pain from all the rate hikes eventually hits.
The most recent hint on inflation came from the CPI data Wednesday morning that showed consumer prices rose 0.2% in August, in line with consensus, and came in up 2.5% year over year, slightly below consensus. Interestingly, core inflation, which strips out food and energy, rose 0.3% in August, slightly higher than consensus, although the headline core inflation number was in line with expectations at 3.2%.
Shelter costs remain an issue and rose 0.5% in August, the highest monthly increase since January. Transportation services also rose 0.9% in August, the highest monthly increase since April.
CPI Trends chart by author. Data source: Federal Reserve Economic Data. * = seasonally adjusted numbers.
What the data means
The CPI shows that inflation is falling and inching toward the Fed's 2% inflation target. However, it's not such a surprising fall to suggest that demand is declining at an alarming speed -- at least at this time. Treasury yields rose following the report. The data therefore hints that the Fed will lower the federal funds rate by a quarter point next Wednesday instead of a half point.
According to FedWatch, a tool that looks at futures prices on the Federal Funds rate, 85% of those traders expect a quarter-point cut, while 15% expect a half-point hike (as of the morning of Sept. 11). One day prior, the split was 66% in favor of a quarter-point cut and 34% in favor of a half-point cut.
While I can't predict the economy's future, I think a quarter-point cut is the better scenario for the market because a half-point cut likely means the economy is in more trouble and could fall into a recession. Jumbo rate cuts and hikes also lead to more uncertainty and volatility, which can be difficult to navigate.
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