Bank of America: Tonight’s “downward surprise” in CPI will have a greater impact; if core CPI unexpectedly drops, a September rate hike may be off the table

Tonight, the US July CPI data will serve as a key litmus test for whether the Federal Reserve will raise rates in September.

According to Chasing Wind Trading Desk, on August 11, Bank of America Merrill Lynch rate strategist Meghan Swiber and others released a research report providing a forward-looking analysis of the US July CPI data. Their baseline forecast is for overall July CPI to rise by 0.1% month-on-month (+3.4% year-on-year), and for core CPI to rise by 0.2% month-on-month (+2.5% year-on-year)—both in line with market consensus. Bank of America maintains its baseline forecast of three rate hikes this year.

However, analysts said, US Treasury yields and the US dollar are more sensitive to “downside surprises” in inflation than to equally sized “upside surprises.” With June CPI already softer than expected, if July again comes in below expectations, this would directly shake the basis for a Fed rate hike in September.

Baseline Scenario: Inflation Returns to Trend

Bank of America characterized the downward CPI surprise in June as a “one-off event” and expects the July data to return to the recent trend.

The analysts’ baseline forecast is:

• Headline CPI: +0.1% month-on-month, +3.4% year-on-year. Although rising tensions in the Middle East have brought renewed volatility in energy prices, average gasoline station prices in July actually came in below June levels, while food inflation is expected to remain on its trend at +0.2% monthly.

• Core CPI: +0.20% month-on-month, +2.5% year-on-year, the lowest reading since January this year. Core goods inflation remains mild, and core services (including housing and non-housing services) are expected to rebound to trend, at around +0.3% month-on-month.

• Balanced Two-Sided Risks: Volatile components like airfares, used cars, and lodging out may outperform expectations; but the downtrend in auto insurance may also continue.

Under this forecast, a September rate hike is not guaranteed—the key still lies in the subsequent core PCE data.

Key Judgment: Downside Inflation Surprises Have Greater Impact

Analysts wrote: “We expect US rates and the US dollar to react more to downside surprises than to upside surprises of equal size.”

The bank forecasts:

• If the data is strong (core CPI +0.3% MoM): The September rate hike comes back on the agenda, but it is not ‘locked in’—because there will still be August data before the September FOMC, and Chair Waller’s stance is clearly cautious. The final decision remains uncertain.
• If the data is soft (core CPI +0.1% MoM): A September hike is largely off the table, and the roughly 30bp of rate hike priced in for the rest of the year by markets will face a significant challenge.

In other words, strong data only “opens a door,” while soft data would “close a door.”

US Treasury Rate Market: More Sensitive to Moves Down than Up

The drop in US Treasury yields triggered by a downside inflation surprise is significantly larger than the rise caused by an upside surprise. Looking at the specific numbers:

Analysts said that positioning further magnifies this asymmetry. CTAs and active bond funds currently hold a large amount of short duration positions, with short positions particularly concentrated at the front end. If the inflation data comes in soft, short-covering will drive a bull steepening of the yield curve, amplifying the downside move.

The Bloomberg Fed Sentiment Index also shows that current Fed commentary is moderately hawkish; this means that if the data is soft, there is more room for officials to turn dovish than for them to further turn hawkish if the data is strong.

Core PCE Is the Fed's True Anchor

Analysts proposed three scenarios for core PCE:

Scenario 1: Core PCE 2-month average ≥25bp September rate hike “almost a done deal.” At that point, core PCE YoY will remain at 3.3%. Even if methodological changes bring a 20–30bp downward revision, it will still be above 3%. Bank of America thinks this would be enough to bring Waller, Cook, Jefferson, and Barr into the hawkish camp with Hammack, Logan, and Kashkari.

Scenario 2: Core PCE average <20bp September rate hike is basically off the table. But Bank of America adds, “Even so, inflation remains high. We still think higher rates are needed to bring underlying inflation back to 2%,” so another rate hike later in the year remains possible.

Scenario 3: Core PCE average between 20–25bp September rate hike becomes a coin toss. At that point, Chair Warsh will have votes to both hike and pause; the key will lie in whether his recent comments signal true hawkishness or are a continuation of his dovish stance at the July press conference.