Two back-to-back inflation reports showing annual price growth slowing have made it very likely that the Federal Reserve will finally cut interest rates at its next meeting in September.
Inflation, as tracked by the consumer price index, fell below 3% for the first time since right after President Joe Biden and Vice President Kamala Harris were sworn into office. Annual inflation increased by just 2.9% in July, and while it remains above the Fed’s 2% target, the drop is still good evidence that the higher interest rates have worked to slow inflation.
The day before, inflation, as measured by the producer price index, declined to 2.2% for the year ending in July, the Bureau of Labor Statistics reported.
The duo of reports, coupled with a weak July employment report, makes it very likely that the Fed’s long-awaited pivot to cutting rates will begin the next time the Federal Open Market Committee meets on Sept. 17 and 18.
“It’s hard to construct a scenario where the Fed doesn't cut interest rates in September,” Mark Hamrick, senior economic analyst at Bankrate, told the Washington Examiner. “I think the key questions yet to be answered are, what is the magnitude of that cut, as well as the future trajectory of rates?”
Investors are split on just how much the Fed will cut, though. The Fed usually raises and lowers its interest rate target by a quarter of a percentage point but can conduct even bigger cuts or increases should it deem it necessary.
Investors put the odds of a 0.25-point hike in September at about 65%, according to the CME Group’s FedWatch tool , which calculates the probability using futures contract prices for rates in the short-term market targeted by the Fed. Investors see a 36% chance of an even bigger 0.5-point increase.
Dan North, a senior economist with Allianz Trade Americas, told the Washington Examiner that his group is forecasting a 0.25-point reduction at the Fed’s September meeting. After that, it predicts cuts of the same magnitude at the Fed’s November and December meetings, bringing the end-of-the-year rate target from 4.50% to 4.75%.
Hamrick said the declines in inflation must also be examined through the lens of the latest employment report.
The economy added 114,000 jobs in July, far fewer than expected, and the unemployment rate rose 0.2 points to 4.3%, the Bureau of Labor Statistics reported. That was a pretty big miss from expectations that more jobs would be added and the unemployment rate would remain at 4.1%.
“The Federal Reserve really has to begin to think about how it juggles the dual mandate of maximum employment and stable prices and considers that rates are probably significantly too restrictive relative to where they need to be,” Hamrick said.
After that lackluster July employment report, there was a wave of panic that built among investors that the Fed had held rates too high for too long, and many investors began to anticipate a big 0.5-point rate cut in September or perhaps an emergency rate cut before that meeting. But North said since then, cooler heads have prevailed.
“I’m pretty sure that was a knee-jerk reaction from the financial markets. Financial markets are driven by people who are, by definition, often emotional and rational,” North said.
Notably, the Fed likes to wait and see what trends are rather than monthly changes. So, this past report could just be an aberration, but if the August employment report also shows the labor market cooling, it would elevate the importance of trimming rates in order to stave off job loss and unemployment growth.
North said between now and September, there is unlikely any economic data that could make the Fed likely to hold rates steady for another meeting. Still, there is always the specter of exogenous shocks or geopolitical risks that could complicate things.
One of the biggest upside risks to inflation is the Middle East.
“If there is an interruption in the global energy supplies, that could send gas and diesel prices back up, and it could reverse some of the progress that has been made on inflation,” Bill Adams, chief economist for Comerica Bank, told the Washington Examiner.
Israel is fighting a war against Hamas in the Gaza Strip, although Iran, a key ally of the terrorist group, is the bigger factor. Hamas’s former leader, Ismail Haniyeh, was assassinated in Tehran using an explosive device last month. Iran has blamed Israel and has vowed to attack.
Iran has not retaliated, but there have been widespread reports that an attack is imminent. If Iran and Israel get embroiled in a wider conflict, it could send energy prices spiraling. Hezbollah, a Lebanese-based terrorist group allied with Iran, has also been lobbing rockets into Israeli territory, further raising the temperature in the region.
But taken together, the falling inflation and likelihood of a preelection rate cut are good news for the Harris campaign. Voters gave the Biden administration low marks on the economy, in large part due to years of cumulative inflation. So, any declines are welcome to the Harris campaign.
“We have more work to do to lower costs for hardworking Americans, but we are making real progress, with wages rising faster than prices for 17 months in a row,” Biden said in a statement.
But Republicans are working hard to tie Harris to Biden’s inflation legacy, using the phrase “Kamalanomics” to disparage the administration’s handling of the economy.
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“Under Kamala Harris, everything costs 20% more than it did under President Trump, working families are having to spend 30% more for baby food, and the price of gasoline is up 50%,” said Karoline Leavitt, the Trump campaign national press secretary. “America cannot afford another four years of Kamala’s failed economic policies.”
The Fed will make its next interest rate decision on Sept. 18. All economic data leading up to that, including August’s employment report, will be closely scrutinized by the Fed.
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