The thesis

The Fed Chair Powell has clearly stated at the Jackson Hole speech that the Fed’s focus has shifted from the inflation mandate to the unemployment mandate, and thus, signaled the potential beginning of the interest rate easing cycle at the September FOMC meeting, which is next week.

The labor market data has not deteriorated further over the last 4-5 weeks, in fact, the unemployment rate fell from 4.3% to 4.2%, and the initial claims for unemployment have been falling. The Fed could still start easing in September with a 25bpt preventive cut, given the unfolding trend of weakening labor market. However, the market is begging for the 50bpt cut, mostly to delay the bursting Gen AI bubble.

The last hurdle before the expected Fed cut is the CPI report on Wednesday. Given that the Fed’s focus is now on the labor market, the CPI data release will be a “low” hurdle” to jump over, unless there is an unexpected spike, which seems to be unlikely. The only issue seems to be whether the Fed cuts by 25bpt or 50bpt. The CPI release is likely to confirm the 25bpt cut, which might not be sufficient to stop the stock market selloff.

The August CPI report expectations

The US Bureau of Labor Statistics is set to release the CPI inflation data for August on Wednesday. The consensus expectations are that the core CPI will increase by 0.2% MoM, which would decrease the annual core CPI to 3.1% (from 3.2%). The headline CPI is also expected to increase by 0.2% MoM, but due to the base effects, this would cause a larger drop in annual CPI to 2.6% (from 2.9%).

Looking at the recent trend in core CPI, this would be the fourth month in a row where core CPI is at the Fed’s monthly target 0.1-0.2%, which is consistent with the 2% annual inflation target. If this trend continues, the core CPI could fall to 2.5% by the year-end, and this is consistent with 2% core PCE inflation.

However, if the August monthly core CPI comes at 0.3%, above the expectations, the streak of positive inflation data would be broken, and this could jeopardize the Fed’s easing plans.

The Cleveland Fed published the InflationNOW data, and their prediction is that the August core CPI will come at 0.26%, which would be rounded to 0.3%. In this case, the annual CPI would stay at 3.2% or possibly increase to 3.3%. More importantly, the Cleveland Fed expects the September core CPI to increase by 0.27% MoM, which would also be rounded to 0.3%.

To be fair, InflationNOW also predicted a monthly core CPI of 0.27% for July, and they were wrong, as the number was reported at 0.2%. Thus, it’s possible that their statistical model overshoots this time as well, although the empirical assessment of InflationNOW predictions has been positive:

We find that our inflation nowcasts have performed relatively well in these comparisons, both over a long sample and a short sample that focuses on the period since the start of the COVID-19 pandemic.

However, if the Cleveland Fed prediction turns out to be accurate for August, the Fed could be forced to delay the interest rate cut to November, especially given the recently better labor market data.

The BLS notes that there is a Sampling Error in the CPI at the end of each CPI report:

For example, for a 1-month change of 0.2 percent in the all-items CPI-U, we are 95 percent confident that the actual percent change based on all retail prices would fall between 0.14 and 0.26 percent.

So, if the monthly CPI comes at 0.2%, the true inflation could be anywhere between 0.1% and 0.3% rounded. It’s a very wide range, and the Cleveland Fed prediction is within the range.

What to focus on the CPI report?

There are two broad categories that are still above 5% annual inflation: Shelter at 5.1% and Transportation at 8.8% (insurance and maintenance/repair).

Shelter inflation is 36% of the total CPI index by weight; thus it is the most important component of total inflation. Transportation inflation is 6.5% of the total CPI index; thus, these two components account for almost 43% of total inflation.

Shelter inflation

The return to price stability requires the stabilization in the shelter inflation, given its weight in the CPI. In July, Shelter inflation increased by 0.4%, which was above the 0.2% increase in June. Thus, it’s important to monitor Shelter inflation for August, the Fed would like to see the 0.2% number.

In fact, the key argument for an expected return to price stability is the expected fall in rents, which is based on the evidence that market rents have been falling, and especially the new tenant rents for the same rental units, as estimated by the New Tenant Index.

The New Tenant Index was down by -1.1% in Q2 2024, and it’s obvious that the pandemic spike in the rents is over, and the CPI data is measuring this with a significant lag. More importantly, we could be facing a deflationary shock soon, as the falling rents start to be reflected in the official CPI data.

Implications

The August CPI is the last hurdle before the expected Fed cut at the September FOMC meeting, but the relative importance of inflation is now smaller, given the Fed’s focus on unemployment mandate.

Thus, unless core CPI comes much higher than expected, the Fed is likely to cut in September by 25bpt. However, the market needs a 50bpt cut, and if the core CPI comes weaker than expected at 0.1% MoM, this could possibly increase the chance of a 50bpt cut.

The S&P500 (SP500) is currently facing a key support near 100dma, after the selloff last week – and it’s caused primarily by the Gen AI bubble burst, led by Nvidia (NVDA).

I expect that if the core CPI comes at 0.1% and the probability of the 50bpt cut increases above 50%, the S&P500 could bounce off the 100dma support, into the Fed meeting the following week, possibly to the 50dma resistance.

However, the 100dma support is likely to eventually be broken regardless, since the Fed cuts can only delay the Gen AI bust. Thus, I see the S&P500 next at the 200dma support at 5147. This is more likely to be a short-term bottom before a more meaningful bounce.

What happens after depends on when the recession arrives. Ultimately, the 200dma support will be broken too, as the recessionary bear market unfolds.