CPI Preview- The debate between a 25 or 50 bps rate cut

The Bureau of Labor Statistics is scheduled to release the July Consumer Price Index (CPI) report tomorrow, a key economic indicator that could significantly influence financial markets and Federal Reserve policy. Analysts are closely watching this release, as it will provide critical insights into the state of inflation in the U.S. economy. The report is expected to show that the Core CPI, which excludes volatile food and energy prices, will increase by 0.2% month-over-month (MoM), slightly above the 0.1% increase seen in June, and by 3.2% year-over-year (YoY), down from 3.3% in June. The headline CPI, which includes all items, is also projected to rise by 0.2% MoM, up from a slight decline of -0.1% in June, and by 2.9% YoY, down from 3% in the previous month.

This morning's Produce Price Index (PPI) came in cooler than expected. This has helped drive equities higher as market participants consider a 50 basis point cut by the Fed at the upcoming September meeting. If CPI comes in cooler than expected, then the anticipation of a 50 bps move will increase and provide a further tailwind to equities. We do not believe a hotter number would disrupt expectations for a Fed rate cut but it would bear watching following comments today by Atlanta Fed President Raphael Bostic who cautioned that the Fed should not move too early. As a reminder, the markets will see one more CPI report in September before the fed moves.

One of the critical components of the CPI report is shelter costs, which have been a significant driver of inflation over the past year. Shelter inflation, particularly in the form of rent and owners' equivalent rent (OER), has remained elevated due to the pandemic-related surge in housing demand. However, there are signs that shelter inflation is starting to moderate. In June, shelter inflation slowed to a 0.2% MoM increase, down from 0.4% earlier in the year. If this trend continues in July, it could contribute to a more subdued overall inflation rate, aligning with the Fed's target of 2% inflation.

Energy prices are another key factor that could impact the July CPI report. The decline in energy prices has been a major contributor to the recent disinflationary trend. In June, the energy index fell by 2%, driven by a sharp 3.8% drop in gasoline prices. While energy prices are expected to have stabilized somewhat in July, any significant change could either reinforce or counteract the broader disinflationary momentum. Analysts are also watching geopolitical developments, particularly in the Middle East, which could disrupt energy supplies and push prices higher, potentially reversing some of the recent gains in inflation control.

The July CPI report will be particularly important for shaping market expectations around Federal Reserve policy. Federal Reserve Chair Jerome Powell has emphasized that favorable inflation data is essential for considering rate cuts, with many market participants looking to September as a potential pivot point. According to Sevens Research, a "good" CPI report—defined as Core CPI below 3.4% YoY and Headline CPI at 3.1% or lower—could almost guarantee a rate cut in September and drive further gains in the stock market. On the other hand, a "bad" or "ugly" CPI report, with higher-than-expected inflation readings, could delay any rate cuts and lead to a negative market reaction.

Investors have already been positioning themselves in anticipation of the July CPI report, with many moving into more defensive assets such as bonds, cash, and healthcare stocks, while reducing their exposure to equities, particularly in sectors like technology and European markets. The bond market, in particular, is pricing in expectations for the Fed to cut rates by 75 basis points by the end of 2024, with further cuts anticipated in 2025. This outlook reflects a growing belief that the U.S. economy could enter a mild recession in the coming year, which would necessitate more accommodative monetary policy.

In conclusion, the July CPI report is poised to be a pivotal moment for financial markets, with significant implications for Federal Reserve policy and broader market sentiment. With analysts expecting modest increases in both core and headline inflation, the report could either reinforce the current disinflationary trend or signal that inflationary pressures are more persistent than previously thought. The outcome will likely shape expectations for the Fed's next move and set the tone for financial markets in the months ahead.