At a time when core inflation pressures remain high, the Federal Reserve may only be able to moderately cut interest rates by 25 basis points in September.
On September 11th Eastern Time, data released by the US Department of Labor showed that the August CPI rose 0.2% month on month, in line with expectations; The year-on-year increase was 2.5%, the smallest growth rate since February 2021. However, in the context of rising housing and other service costs, core inflation has shown some stickiness, with core CPI rising by 0.3% month on month in August, higher than the expected 0.2%; Up 3.2% year-on-year, unchanged from July.
After the release of CPI data, the Chicago Mercantile Exchange's Federal Reserve Watch tool showed that the market expects the probability of the Fed cutting interest rates by 25 basis points next week to be as high as 85%, and the probability of cutting interest rates by 50 basis points to be only 15%. However, the market still expects the Fed to cut interest rates by 50 basis points in a single meeting in the fourth quarter.
The CPI data has little impact on the magnitude of mid-term interest rate cuts. Traders still expect the Federal Reserve to cut interest rates by more than 100 basis points this year, which means that the Fed may make at least one significant 50 basis point rate cut at its November and December meeting.
At the time when the Federal Reserve's interest rate cut came "late", the European Central Bank, which is under greater economic pressure, has already "taken two steps forward". It started the interest rate cut cycle in June this year and "remained inactive" in July before cutting interest rates again in September. On September 12th local time, the European Central Bank announced its latest interest rate decision, cutting the deposit facility rate by 25 basis points and the main refinancing rate and marginal lending rate by 60 basis points.
Core inflation stickiness highlights
Although the overall year-on-year increase in CPI in August fell to 2.5%, which is 0.4 percentage points lower than the level in July and has been declining for five consecutive months, the core CPI index excluding volatile food and energy prices increased by 0.3% month on month in August, higher than the market expectation median of 0.2%.
Behind the stickiness of inflation, housing inflation in August increased by 0.5% month on month and 5.2% year-on-year, which remains an important issue; The transportation service prices increased by 0.9% month on month and 7.9% year-on-year. These two are the main reasons for the high core inflation rate.
Lu Zhe, Chief Economist and Deputy Director of the Research Institute at Fangzheng Securities, told 21st Century Business Herald reporters that the structural manifestation of CPI in July was the intensification of deflation in core commodities, which was the main contribution to suppressing CPI. However, the rebound of housing and super core inflation still has stickiness in service inflation. The August CPI data further highlights the pressure of "de stickiness" in core inflation. Specifically, in terms of data structure, core commodities continue to experience deflation, and core CPI has rebounded more than expected month on month. This is mainly due to the rebound of high volatility items such as self occupied housing conversion, air tickets, and hotels. Although its sustainability remains to be observed, it also reminds the Federal Reserve that the "tail risk of upward inflation" has not been eradicated.
Looking ahead, Lu Zhe predicts that the non quarter on quarter growth rate of CPI in the fourth quarter of the United States will be lower, and next year will depend partly on the election results. Trump's policy of domestic fiscal easing and external tight supply will mean that US inflation faces upward risks on both the demand and supply sides. Under Harris' policy, the upward risk of inflation is relatively small.
In the medium to long term, whether inflation can return to the 2% target still depends on the degree of supply side recovery. The core source of inflation stickiness in the United States lies in service inflation, among which the supply and demand structure of the labor market and its impact on wage inflation are the main influencing factors.
According to Lu Zhe's analysis, based on the non farm payroll data in August, the latest labor supply gap in the United States is 2.55 million, of which the domestic labor gap is 4.58 million and foreign labor contributes 2.04 million. The sustained and significant growth of immigrant labor force is the main contribution to the recent labor supply recovery; The labor force participation rate of the 55+age group recorded 38.6%, with a gap of -1.7% compared to December 2019. The trend of early retirement among Chinese residents has not yet been reversed. Therefore, whether the labor supply can be fully restored will depend on whether immigrants can fill the gap caused by early retirement of their own residents.
Moderate interest rate cuts in September are almost certain
After the release of inflation data, the Federal Reserve is likely to only moderately cut interest rates by 25 basis points in September.
According to Lu Zhe's analysis, the core CPI rebounded more than expected month on month in August, and the sustainability remains to be observed, but it also reminds the Federal Reserve that the "tail risk of rising inflation" has not been eradicated. In the environment of decent non farm payroll data in August and remaining economic resilience, the core inflation that rebounded month on month is basically determined to be reduced by 25 basis points instead of 50 basis points by the FOMC in September.
Renowned macro journalist Nick Timiraos, known as the "voice of the Federal Reserve," also stated that the continued trend of weak inflation has paved the way for the Fed to gradually lower interest rates starting next week, but the unexpected rise in housing inflation has made it difficult for officials to push for even greater rate cuts.
Tony Farren, Managing Director of Interest Rate Sales and Trading at Mischler Financial Group, stated that the core CPI increased by 0.3% month on month, a figure that shook the market. The possibility of a 50 basis point interest rate cut in September has been hit, and now it is almost certainly not an option.
Although there is a high probability that the Federal Reserve will cut interest rates by 25 basis points in September, there is still a possibility of a single 50 basis point rate cut in the fourth quarter. The current mainstream expectation is that the Federal Reserve will cut interest rates by a total of 100 basis points within the year, which means that there will be at least one 50 basis point rate cut in the next three meetings. Some Wall Street institutions have more dovish expectations, and Citigroup has abandoned its forecast of a 50 basis point Fed rate cut next week, but still maintains its expectation of a total rate cut of 125 basis points this year.
Lu Zhe believes that the magnitude of a single interest rate cut in the future will directly depend on the rate of economic weakness. If the demand in the labor market or the rate of deterioration of the unemployment rate exceeds expectations, or if there is another risk event in the financial system under a tight liquidity environment, it is still possible to significantly lower interest rates at a future meeting.
The Federal Reserve may welcome a mild interest rate cut cycle
Behind the Federal Reserve's upcoming first reduction, it actually means that the risks ahead have increased, and the Fed is "lowering pressure" ahead of schedule.
Tim Duy, Chief US Economist at SGH Macro Advisors, stated that the upward trend of inflation in the US has largely come to an end. Now, as the balance of risk shifts to the employment task, the Federal Reserve's efforts to curb inflation may be excessive, and this risk must be taken very seriously.
On September 10th, the breakeven inflation rate of 10-year US Treasury bonds fell to 2% at one point, and the bond market is concerned that the US inflation rate may slow down excessively. Historically, CPI has often been about 0.4 percentage points higher than the Federal Reserve's most favored inflation indicator, the core PCE price index. This indicates that some investors believe that the average inflation rate over the next decade may be lower than the Federal Reserve's 2% target.
Lu Zhe analyzed that if inflation cools excessively in the future, it means that economic demand is weakening too quickly. At present, the risk of the Federal Reserve's slow pace of interest rate cuts may lie in the fact that maintaining high interest rates for too long exacerbates the fragility of the financial system, leading to the outbreak of financial risks and economic recession. In terms of US dollar liquidity, recent high-frequency data shows that the liquidity in the US money market is tightening. In an environment where the Federal Reserve continues to shrink its balance sheet and interest rates remain relatively high, coupled with ongoing concerns about commercial real estate, there is a possibility of a financial system outbreak such as the Silicon Valley banking crisis. At that time, weak economic fundamentals may be unable to withstand the impact of financial risks, leading to systemic risks and rapid economic decline.
From an optimistic perspective, moderate easing by the Federal Reserve will benefit emerging markets and alleviate pressure. Barclays believes that emerging market assets have been constrained by Federal Reserve policies for most of this year, but the situation is rapidly changing as the Fed approaches interest rate cuts. The Federal Reserve's shift towards a more moderate easing stance is sufficient to support the recent repricing of emerging market interest rates, and has been implemented in some countries such as Mexico, Czech Republic, Israel, and India.
Overall, the more mainstream view is that the Federal Reserve is entering a period of moderate interest rate cuts. Erik Norland, Managing Director and Chief Economist of CME Goup, told 21st Century Business Herald reporters that the rate cuts in this easing cycle may be relatively small. During the early 1990s, early 21st century, and global financial crisis, each of these three economic recessions saw the Federal Reserve cut interest rates by about 500 basis points. But this time the inflation rate is relatively high, which may limit the extent of the Federal Reserve's interest rate cuts, so even if the economy declines, the magnitude of interest rate cuts will not be as large as before.
Norland analysis shows that for a long time from the mid-1990s to 2020, inflation rates in the United States and other places remained relatively stable and low. During this period, global free trade developed rapidly, and after the Cold War, defense spending in various countries decreased. Now, the trend of free trade is changing, global protectionism is on the rise, geopolitical risks are intensifying, and military expenditures of various countries have also increased. These conditions may all lead to a high inflation environment in the future.