The August CPI report was slightly higher than expected, dampening market hopes for a 50 basis points Fed cut next week. While the report will certainly not pose an obstacle to a policy cut next week, with core CPI rising at its fastest pace in four months and economic activity indicators still painting a mixed picture of the economy, policymakers may find it tough to justify a sizeable half point reduction in the policy rate.

Report details:

  • Monthly headline inflation rose 0.2% in August, as expected, bringing the annual rate to decelerate further to 2.5%—from 2.9% prior—the smallest annual increase since February 2021. Meanwhile, core inflation, which strips out food and energy, grew more than expected, rising 0.3% in the period, keeping the annual rate flat at 3.2%. Three-month annualized core inflation ticked up to 2.1% as a result, after declining in the prior month.
  • The rise in core inflation was primarily driven by the 0.5% increase in shelter costs in the month, the most since the start of the year, and up from 0.4% in July. So far, the much-awaited sustained deceleration in shelter inflation remains elusive. Transportation prices also rose 0.9% in the period, led by auto insurance and the volatile airline fares category, which rose 0.6% and 3.9%, respectively. Overall, core services inflation proving sticky is helping keep overall core inflation elevated.
  • Meanwhile, core goods inflation continued to see an outright deflationary trend, with prices declining 0.2% in the period. This was led by used vehicle prices, household furnishings, and medical care, which declined 1%, 0.6%, and 0.2%, respectively.
  • The Fed’s preferred supercore inflation measure, which excludes shelter from core services and is significantly driven by wage costs, rose 0.3% in the period, an increase from its 0.2% pace in the prior month. This leaves the annual supercore figure flat at 4.5% in August.

Policy outlook

Inflation has decelerated significantly from its 9.1% peak last year and, with headline inflation now in touching distance of the 2% target, it is clearly time for the Fed to start lowering rates. While the timing for the first cut is decided (next Wednesday, September 18, at 2pm ET), the magnitude of the first cut is still in question. Weakening labor market data have raised expectations of a 50 basis points cut, while mixed economic activity numbers—and now inflation numbers—are swinging the pendulum back to 25 basis points.

Our own expectation for a 25 basis points cut next week remains unchanged. As long as there is ambiguity about the strength of the economic picture and lingering concerns about the stubbornness of inflation, the Fed is likely to default to the standard 25 basis points.

Unfortunately, risk assets would likely not receive this decision positively, fearing that the Fed is behind the curve and raising expectations that a 50 basis points cut will need to follow in either November or December if the Fed is to avert recession. Buckle up, the next few weeks are likely to be rocky.

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