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The July Consumer Price Index (CPI) inflation report, scheduled for release Wednesday, could play a crucial role in shaping investor expectations ahead of the Federal Reserve's September meeting.
Depending on the inflation data, markets may gain clarity on whether to expect a modest or substantial interest rate cut next month.
If inflation slows more than anticipated, it would reinforce the view that inflation is nearing the Fed’s 2% target. This scenario would likely push traders to increase bets on a larger rate cut by 50 basis points in September. Conversely, if inflation comes in as expected or higher than expected, it could signal a setback in the disinflationary trend, increasing the likelihood of a more modest 0.25% rate cut.
At present, the market is nearly evenly split, assigning a 50-50 chance between a 25-basis-point rate cut and a more substantial 50-basis-point cut.
“We expect some of the June’s downside inflation surprise to reverse in July,” wrote Bank of America’s economist Michael Gapen.
The investment bank acknowledges that while the risks to economic activity are tilted to the downside, concerns about a hard landing are overstated. They also believe there is a low probability that the Fed will need to implement large or inter-meeting rate cuts.
Bank of America expects both headline and core CPI inflation to rise by 0.25% and 0.22% month-over-month, translating to 3.0% and 3.3% year-over-year, respectively.
They also indicated that if shelter inflation posts another 0.3% monthly increase, the Fed’s confidence in the disinflationary trend could strengthen further. The bank continues to project 25-basis-point rate cuts from the Fed in both September and December.
The June inflation report, released on July 11, delivered a downside surprise in the consumer price index. Headline CPI inflation slowed from 3.3% in May 2024 to 3% in June 2024 on a year-over-year basis, below the 3.1% economists had expected. The monthly reading notably declined by 0.1%, marking the first month-over-month contraction in the CPI since May 2020.
Core inflation also decelerated, coming in at 3.3% year-over-year, below the 3.4% consensus estimate and down from the previous 3.4% reading.
Despite the cooler-than-expected inflation data, markets responded bearishly.
The report heightened expectations for Fed rate cuts but prompted traders to move away from growth-linked assets like stocks, seeking refuge in recession hedges such as bonds and gold.
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