Fed's Interest Rate Decision: Will Incoming July Inflation Data Tip The Scale?

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.

July’s CPI Preview: What Do Economists Expect?

• Economist consensus as tracked by TradingEconomics predicts the CPI index to rise by 2.9% year-over-year in July 2024, slightly down from the 3% increase recorded in June.
• On a monthly basis, the CPI is projected to edge up by 0.2%, rebounding from the previous month’s decline of 0.1%.
• When excluding volatile categories like energy and food, the core CPI is forecasted to rise by 3.2% year-over-year, a slight decrease from June’s 3.3% increase.
• On a monthly basis, the core CPI is anticipated to advance by 0.2%, up from the 0.1% rise reported in June.
• The Cleveland Fed's Inflation Nowcasting model predicts that the headline CPI and core CPI will both increase by 3% and 3.3% year-over-year, respectively, or 0.24% and 0.27% month-over-month, in July.

Bank Of America’s Take On July Inflation Data

“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.

How The Market Reacts To Inflation Reports

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.

• The S&P 500, tracked by the SPDR S&P 500 ETF Trust SPY, fell 0.9%.
• The Nasdaq 100, tracked by the Invesco QQQ Trust QQQ, tumbled 2.2%.
• U.S. Treasury bonds, followed by the iShares 20+ Year Treasury Bond ETF TLT, rallied 1%.
• Gold, tracked by the SPDR Gold Trust GLD, soared 1.8%.
• The U.S. Dollar Index (DXY), as tracked by the Invesco DB USD Index Bullish Fund ETF UUP, fell 0.5%.

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Image created using artificial intelligence via Midjourney.