A touch-hotter-than-anticipated August CPI report nudges the Fed toward a 25 bps rate cut at its meeting next week. However, inflation remains cool enough that the Fed could still surprise with a 50 bps cut to get ahead of further weakness in the labor market or simply project the possibility of larger cuts down the road. Mortgage rates, having priced in an aggressive cutting cycle into 2025, are unlikely to move much until we hear from the Fed.
Core CPI, which excludes the volatile food and energy categories, increased 0.3% from a month ago in August, above expectations of a 0.2% increase. This was the first upside surprise after four consecutive months of mild inflation readings. The increase was rounded up from a 0.28% monthly increase, making it just a hair above the median forecast of 0.21% and allowing the year-over-year increase to come in at 3.2% as expected. Economists will have a better sense of how the Fed’s preferred inflation gauge—core PCE—will come in after tomorrow’s PPI data.
Some of the core CPI increase came from volatile categories such as apparel and airline fares, but the lion’s share came from an uptick in housing inflation. The rent of primary residence and owners’ equivalent rent categories both jumped this month from 0.2% to 0.3% MoM and 0.3% to 0.4% MoM, respectively. However, these are backward looking categories that do not reflect current economic conditions as they lag market pricing data by more than a year. Indeed, Redfin’s rental market data shows that rents are essentially flat relative to two years ago.
Slightly firmer-than-expected inflation alongside a labor market that doesn’t appear to be deteriorating further will make a 25 bps cut the easy choice for the Fed next week, but larger cuts are still a possibility. With only three meetings remaining in 2024, projecting 25 bps of cuts per meeting risks disappointing markets, which are expecting more than 75 bps of cuts by the end of the year. It also risks further deterioration of the labor market, which Chair Jerome Powell has said they would not welcome, if they are not able to bring interest rates back to neutral fast enough. One possibility is that they pair a 25 bps cut with a projection of larger cuts in the future, either officially through the summary of economic projections, or unofficially through Powell’s comments during the press Q&A. That is the most likely outcome. Another less likely possibility is that Powell makes the decision to cut by 50 bps next week because interest rates are currently out of line with the economic data and brings the rest of the committee along with him even though markets are tilted toward a 25 bps cut and no Fed speakers hinted at a 50 bps cut before the blackout period began last Saturday. That would be a bold move, even if the data and balance of risks justify it, especially because next week’s meeting is the last one before the election. But by having remained unusually quiet, the Fed has left the door ever so slightly open to a surprise.
