US CPI Preview: Markets Brace for Lowest Inflation Since 2021

As the US economy approaches a key turning point in the inflationary cycle, market participants are eagerly awaiting the upcoming Consumer Price Index (CPI) report. The headline CPI is expected to show a significant cooling, potentially falling to 2.6% year-over-year, the lowest level since 2021.

This report, due just days before the next Federal Open Market Committee (FOMC) meeting on September 18, could have significant implications for the Federal Reserve's next interest rate decision.

A Gradual Return to Target Inflation

The consensus for the headline CPI is a modest 0.2% increase month-over-month (m/m) and 2.6% increase year-over-year (y/y). Should these numbers come in as expected, it would mark a further step toward bringing inflation back to the Fed's long-term target of 2%.

This data would reflect a steady cooling in price pressures that began after inflation peaked in mid-2022. A reading below the previous month's 2.9% would indeed be the lowest since 2021 and could signal that inflation is no longer the major economic challenge it once was.

The recent sharp decline in oil prices is also playing a significant role in moderating inflation. With oil prices having plunged over 25% from the same time last year to $65.80 per barrel, the energy component of CPI is likely to exert downward pressure in the coming months.

This could help temper any potential upside surprises in the near-term CPI readings, allowing markets to focus more on core inflation dynamics.

Core Inflation Remains a Key Focus

While headline inflation provides a broad overview of price trends, the Fed is particularly focused on core inflation, which excludes the more volatile food and energy prices. The consensus expectation for the core CPI is a 0.2% m/m increase and a 3.2% y/y increase.

This relatively sticky core inflation rate is partly due to lagging effects from rising home prices and rents, which take time to filter through to the data. Additionally, the Fed has been closely monitoring "supercore" inflation, defined as CPI services excluding housing.

This measure, which remained elevated at 4.5% y/y in the prior month, highlights that goods inflation is currently doing the heavy lifting in bringing down overall inflation numbers.

The core CPI is crucial in determining the Fed's stance on interest rates. While headline inflation is expected to show marked improvement, any signs that core inflation remains persistently high could temper market optimism and keep the Fed on a more hawkish path.

Implications for the FOMC Decision

The CPI report's timing is critical as it arrives just before the FOMC's decision on interest rates. Current market pricing suggests a 33% probability of a 50 basis points (bps) cut, but this could increase to 40% if both core and headline CPI figures come in below expectations.

A strong consensus among economists points to the Fed cutting by 50 bps; however, there is a sense that the Fed may opt for a more cautious 25 bps cut. The FOMC is weighing the risk of economic softness flagged in the Beige Book against the need to preemptively ease monetary policy.

There is an emerging sentiment that Fed Chair Jerome Powell and his colleagues may want to be proactive in ensuring that the economy does not slow down too much, especially given the signs of slowing job growth and cooling inflation.

This CPI report will thus be a key data point influencing whether the Fed will lean toward a more aggressive or measured rate cut path.

Bond Market Signals and FX Market Implications

The bond market is increasingly signaling that inflation concerns are fading. The yield on US 5-year Treasury notes recently hit its lowest level since 2023, and 5-year breakevens—a measure of inflation expectations—dropped to 1.88%, the lowest since December 2020. This suggests that bond investors are more worried about the Fed undershooting on inflation rather than overshooting.

From a foreign exchange (FX) perspective, the risks appear tilted towards a weaker US dollar. A softer-than-expected CPI report could spark a rally in risk assets, with markets potentially interpreting it as a signal that the Fed is close to achieving its inflation target.

On the other hand, a slight upside surprise in inflation data is unlikely to derail this view, given the recent downward pressure from oil and raw materials prices.

Conclusion: Inflation Fades as the Key Concern for Markets

In summary, the upcoming CPI report is shaping up to be a pivotal moment for both the markets and the Fed. While the days of large market swings based on CPI data may be behind us, this report still holds substantial weight in shaping the near-term policy outlook.

If inflation continues its downward trend, it could provide the Fed with the confidence needed to adopt a more accommodative stance, potentially easing by up to 50 bps in the near future.

However, any signs of stubborn inflation could quickly shift the narrative back to a more cautious approach. Investors should brace for a potentially volatile reaction across bonds, equities, and FX markets as this critical economic data is released.