The new US CPI report showed an annual growth rate of 2.7% while core CPI stood at 3.1% – in line with market expectations. It seems the markets were relieved that the CPI didn’t overshot expectations, thus paving the way for a September rate cut by the Fed, especially after the last jobs report and the 258k downward revisions for previous months that led to the firing of the commissioner of the BLS.
The main issue for the Fed is how tariffs will affect inflation and the job market, and based on that, what should they focus on: stimulating the economy or curbing inflation?
Despite the high uncertainty the Trump tariffs have caused, it’s still unclear their short-term, let alone long-term, effects on the economy. Yes, we all know it will raise inflation, and the weaker dollar will push the prices of imported goods, but will it be transitory? Will we see a massive bump in inflation in the coming months?
In one of the Fed’s notes, the researchers tried to figure out the real-time effect of tariffs put on China in February and March of this year. They concluded these tariffs alone – pre ”liberation day” – raised core PCE by 0.08 percentage points. But more importantly, they argue that the 2018-2019 China tariffs were passed through the core PCE within a couple of months. If this report is correct, then any tariffs that were already levied in previous months may have already passed through. Nonetheless, some tariffs have only recently been implemented that could come through the economy in the coming months.
Despite the spike in tariffs and the constant changes to such policies, for now, inflation expectations aren’t off by much from before Trump 2.0, according to the New York Fed’s survey for the 1-year and 3-year periods.
Inflation expectations: 1-year
Source: Federal Reserve Bank of New York
Inflation expectations: 3 years
Source: Federal Reserve Bank of New York
I wouldn’t put too much weight into these figures, not because they’re incorrect but because it seems people basically look at the current inflation and base their outlook accordingly. The markets aren’t much different: Consider the 5-year, 5-year inflation outlook and CPI; they move in tandem, and thus, as long as inflation doesn’t stray, so do expectations.
Inflation expectations and CPI
Source: FRED
But even if we accept these numbers, they suggest that inflation expectations for the medium term are anchored not too far off their 2% target indicating the whole tariffs saga is expected to have a transitory effect on the economy; and as interest rates still well above the terminal rate, the current Fed’s policy rate continues to curb inflation. Hence, perhaps, the Fed won’t have to fight stagflation, as it did back in the 70s. Thus, the current economic environment is more inclined to accept further interest rate cuts by the Fed, even as core CPI is above 3%.
What does it mean for the Fed?
The markets have already adjusted their outlook after the August jobs report, and for now, a rate cut in September of 25 basis points is nearly a done deal. The markets also expect another one, probably in December.
Table of implied probability of rate cuts by the Fed
Source of data: CME
Will the Fed pull another course correction as it did last year and cut rates by 50 basis points in September? I doubt it. Inflation uncertainty is much higher, and interest rates are a whole one percentage point lower than they were last year. The markets, at least based on future markets, don’t seem to price such a cut in September. I only suspect that a 50 basis point move could become more likely if the September jobs report shows a contraction in labor.
