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.
Without these anchors, we risk a rerun of the type of market turmoil experienced during the first three trading days of August. With the economy weakening, these assurances are crucial to maintaining a stable and well-functioning market, and to avoiding a negative spillover from unsettling market volatility to the economy. They would also help ensure an orderly reconciliation of market pricing with the recent shift in many analysts’ estimation of recession risks and related expectations of Fed policy moves.
While inflation fears have calmed, the maximum-employment side of the Fed’s mandate has become more uncertain. I still estimate a 50% probability of a soft landing, but the left tail of recession at 35% is too fat to ignore (the remaining 15% of the distribution is the right tail of a bigger-but-not-hotter economy due to a series of favorable supply shocks).
The recession-risk scenario is susceptible to adverse external developments such as an escalation of the conflicts between Hamas and Israel and/or between Russia and Ukraine and, domestically, to the Fed falling behind the curve. These risks would undermine the one thing currently supporting the economy’s consumption engine — solid labor income.
Putting this 35-50-15 distribution together with my estimate of the longer-term neutral rate and the likelihood that the equilibrium rate of inflation is around 2.5% — rather than the Fed’s target of 2% — the market’s implied path of 200 basis points of rate cuts may be too aggressive. My estimation of 150 basis points of likely Fed cuts over the next 12 months would change if the highest probability macroeconomic scenario were to shift from a soft landing to a recession. But most of us would be delighted to avoid that outcome even if it implies that current market pricing of Fed action is wrong.
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