US inflation cools case for 50bp cut

With the Federal Reserve (Fed) set to begin its long-awaited interest rate easing cycle at next week’s Federal Open Market Committee (FOMC) meeting, Wednesday’s Consumer Price Index (CPI) inflation report for August was the last big economic release investors could comb for clues as to the the size of the first cut.

The report came mostly in line with estimates, though the figures showed some upward price pressures not too dissimilar from July’s reading. Headline inflation for August was 0.2% month-on-month (mom) and 2.5% year-on-year (yoy), which matched expectations and marked the fifth straight month of disinflation in the yoy figure. Core inflation, however, was slightly higher than forecast at 0.3% mom, the largest rise since April, with the details of the report suggesting the costs of certain key categories remain stubborn. Chief among these was an increase in core services inflation, primarily driven by housing with the all-important shelter component increasing 0.5% in its largest monthly increase since January on the back of stronger than expected owners’ equivalent rents inflation. Other components of services inflation were also firm, with the so-called supercore number (core services excluding housing) at 0.3% mom for August, up from 0.2% in July. On the other hand, goods inflation was the most notable positive detail in the report as core goods prices remained in deflationary territory at -0.2% mom, and the underlying data suggested there still may be more room for that trend to run. 

While inflation data has taken a back seat to labour market readings and economic growth figures in recent months, we believe it is worth highlighting a few relevant takeaways from this latest set of numbers. First, with market pricing putting the chances of a 50bp interest rate cut on September 18 at nearly 50% as recently as last week, we would argue this CPI report likely closes the door on that move by the Fed next week, with markets having since rolled back the odds to under 15% at the time of writing. Second, beyond next week we think medium term investors can find comfort in the broadening of disinflation in the US, while lingering inflationary pressures have continued to narrow. Though this report was not as encouraging as previous months, the data still supports our outlook for further gradual disinflation ahead. Finally, we would note that post-CPI US Treasury yields moved a few basis points higher across the curve, and the reaction in risk assets was largely subdued with credit indices and equities largely unchanged or slightly higher, which tells us the market is now much more comfortable with inflation and attentions are elsewhere.

In our view, this last big data point before the Fed’s rate decision will have done little to shift FOMC members’ increased focus on the labour market and economic activity data as the main drivers of monetary policy in the near term. With the Fed explicitly data-dependent and still at a restrictive rate of 5.50%, it will be this labour and growth data that will be the main driver of the yield curve and fixed income markets in the coming months.