Tonight's US CPI, could it severely impact September rate hike expectations?

Whether the Federal Reserve will raise interest rates in September may be revealed tonight.

The US Bureau of Labor Statistics will release the July CPI data at 8:30 AM Eastern Time on Wednesday (8:30 PM Beijing time). The market generally expects the headline CPI to increase by 0.1% month-on-month, core CPI to rise by 0.2% month-on-month, with the annual rates dropping to 3.4% and 2.5% respectively.

After last week’s unexpectedly weak nonfarm payroll data, this report becomes a key litmus test for expectations of a rate hike in September. If the data is mild, the market may further lower the probability of a September rate hike; if the data proves hotter than expected, it will put additional pressure on the already hawkish Federal Reserve.

Currently, the interest rate futures market prices in a roughly 50% chance of a September rate hike—a classic “coin toss.” Last week’s nonfarm payrolls data showed a drop of 23,000 jobs in July, leading to a clear cooling of rate hike expectations; however, a subsequent rebound in oil prices pushed the odds back to an even split. Meanwhile, three Federal Reserve governors voted in favor of a rate hike at the July FOMC meeting, and several non-voting members also openly signaled their preference for tighter policy, making the hawkish voices considerable within the committee. Tonight’s CPI data will directly influence the direction in which this balance tips.

According to forecasts from institutions such as Goldman Sachs and Pantheon Macroeconomics, this round of CPI data is very likely to fall within expectations and unlikely to repeat last month’s notable volatility.

Goldman Sachs expects July core CPI to rise by 0.19% month-on-month, with the annual rate at roughly 2.47%, both slightly below market consensus; headline CPI is forecast to increase just 0.05% month-on-month, annualized at about 3.35%. The main factor suppressing headline inflation is the decline in energy prices (-2.0%), while food prices are expected to rise moderately by 0.2%.

On the breakdown, Goldman Sachs expects used car prices to rise 0.5% month-on-month, new car prices to rise 0.1%, but auto insurance prices to fall 0.5%; for the housing component, owners’ equivalent rent (OER) is expected to increase 0.23% month-on-month, and rents 0.16%, continuing the recent slowdown trend; for travel services, there is some divergence, with airfares expected to rise 2.0% and hotel prices to drop 1.0%, partly as the demand boost from the World Cup fades.

Pantheon Macroeconomics expects core goods prices to rise by 0.18% month-on-month, the largest jump since September last year, in part due to Apple (AAPL) raising prices on most hardware products by 15% to 30% since June 25. However, the weak services sector will offset this to some extent—the firm forecasts airfares down 1.5% month-on-month, accommodation prices down 1.0%, auto insurance continuing its downward trend, and energy goods prices expected to fall 2.6%, which will drag the monthly headline CPI by about 11 basis points.

Joe Brusuelas, Chief Economist at RSM, said, if July’s CPI comes in close to expectations, “the majority of the committee will choose to ignore supply-side shocks, and the FOMC will keep rates unchanged for the rest of the year,” which would provide some buffer for Fed Chair Waller, who has faced ongoing policy pressures since taking office in May.

However, hawkish forces within the Federal Reserve are gaining momentum. Cleveland Fed President Beth Hammack, one of three officials who voted for a hike in July, said Monday that multiple rate hikes may be needed, stressing that “a single 25-basis-point move may have a very limited impact on the economy.” In addition, non-voting members Schmid and Musalem stated that they would have leaned towards a hike at the July meeting. While Chair Waller acknowledged that tighter current financial conditions are partly substituting for further Fed action, and that the July jobs report and its downward revision have dampened tightening expectations, he also did not explicitly rule out further hikes.

Bank of America maintains its forecast for three rate hikes in the coming months. The bank’s economists wrote in a client note that the July employment report “did not change the overall picture of the labor market,” and that the Federal Reserve’s reaction function remains “highly skewed toward inflation data.” The bank warns that if the average core CPI monthly increase reaches 0.25% in the next two months, “the Fed will almost certainly start raising rates in September;” if the average is below 0.2%, the hike will be delayed; if it falls in between, September is still a “coin flip.”

J.P. Morgan’s market intelligence team offered the following scenario analysis for CPI data:

• If core CPI exceeds 0.30% month-on-month, the S&P 500 is expected to fall 1.5% to 2.5%, with a 5% probability;
• If it falls in the 0.25%-0.30% range, the index is expected to drop 0.5% to 1.25%, probability 25%;
• If it lands in the 0.20%-0.25% range (the highest probability scenario, about 40%), the index is expected to rise 0.25% to 0.75%;
• If it is below 0.20%, gains could widen to 0.5% to 2%. Overall, the bond market’s reaction to above-expected inflation will be more pronounced than stocks.

It is notable that the option-implied volatility for contracts expiring August 12 is about 0.9% for the day, slightly below the recent average of roughly 1.1%, showing that the market does not expect extreme outcomes from tonight’s data.

Wells Fargo analysts led by Ohsung Kwon have issued a warning to investors to set up hedges before the CPI release. The sentiment indicator is currently at 1.4, the strongest “sell” signal since January 2018. “We think hedging costs are low, and prefer to hedge against hotter-than-expected data,” the analysts wrote, “If CPI surprises to the upside, the market narrative will quickly pivot to stagflation concerns, especially after last week’s weaker jobs data.” However, Wells Fargo also pointed out that Q2 corporate profits grew 30% year-over-year—8% above market expectations—the strongest pace in more than four years, which still provides some support for equities.

Even though the short-term inflation outlook appears mild, Societe Generale analyst Andrew Lapthorne points out the stock market’s structure is sending warning signals. The bank’s stock market inflation proxy index, which tracks developed market equities most closely tied to inflation, has outperformed the MSCI World Index by a wide margin in the past 12 months, surging 71% cumulatively. Lapthorne said:

“The market no longer expects a contradictory ‘strong earnings growth + rate cuts’ mix, but now believes such strong earnings growth typically correlates with a need for rate hikes.”

Meanwhile, commodities linked to the AI supply chain face upward pricing pressures. Reportedly, the surge in memory prices could add as much as 0.5 percentage points to core PCE. Goldman Sachs expects July core PCE to show a hefty 0.26% monthly increase, part of which reflects Q2’s stock gains feeding through, with a lag, into portfolio management service costs. A methodological adjustment for this component is set for the end of September, which may see the relevant data revised down, but another revision in December may reintroduce a strong relationship.

Even if tonight’s CPI results are clear, the direction of a September rate hike is still not settled. Before the September 16 FOMC meeting, the Fed will also receive August nonfarm payrolls, August CPI, and August PPI, while August PCE will only be published after the meeting. This means policy expectations still have ample room to shift in the coming weeks.

All things considered, the highest probability scenario is data matching expectations—neither enough to reignite rate hike odds for September, nor to completely dispel tightening fears in markets. The final say in the hawk-dove debate is still in the hands of the subsequent data—and Chair Waller.