The Market May Be Too Aggressive on Fed Rate Cuts

The inflation numbers this week — both for producer and consumer prices — have served to reassure markets in two distinct ways: confirming continued progress in the battle against high price increases and supporting the ongoing shift in the Federal Reserve’s focus from its inflation mandate to its employment mandate. This leaves the door wide open for an interest rate cut in September, but it does not support the terminal rate that the market is pricing. Indeed, that destination looks about half a percentage point too low.

The producer price data released on Tuesday were softer than consensus forecasts, both at the headline level and after stripping out the volatile food and energy categories. This good news triggered a significant stock market rally and a noticeable drop in government bond yields. These market reactions were further validated by Wednesday’s consumer price numbers, which essentially met consensus forecasts. The headline measure, rising 2.9% in July from a year earlier, had a two handle for the first time since 2021.

Based on these inflation readings, it is virtually certain that the Fed will finally start its cutting cycle in September, most likely with a 25-basis-point easing (though a 50-basis-point move is not out of the question by any means). At first sight, this supports the market view that we are now looking at a total of 200 basis points of reductions, bringing the fed funds rates to 3.25%-3.5%, over the next 12 months.

For these expectations to be sustained, this week’s data needs to be reinforced in two key ways. Firstly, Chair Jerome Powell's remarks at Jackson Hole next week need to be supportive and comprehensive. This would include him clarifying his views about the neutral interest rate that neither stimulates nor restrains the economy, the path to getting there, and how precisely the Fed will pursue a “sustainable 2%” inflation target. Secondly, a well-telegraphed Fed cutting cycle is initiated in mid-September, consistent with what is priced by markets.