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Traders anticipate a significant Federal Reserve rate cut, possibly overlooking inflation risks.

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TraderKnows
08-14

The July PPI rose less than expected, easing inflation concerns. This has increased traders' confidence that the Federal Reserve will make several rate cuts by mid-2025.

According to the CME FedWatch Tool, an increasing number of federal funds futures traders expect that interest rates could drop by as much as two percentage points by next July. This implies that the Federal Reserve's main interest rate target could be lowered from the current 5.25%-5.5% range to about 3.25%-3.5%. This expectation includes a possible half-percentage point rate cut in the Fed's policy statement on September 18, as well as further easing measures by the end of the year.

In other words, traders have returned to the early-year anticipation of rate cuts, but this time due to concerns about economic slowdown or recession rather than inflation pressures. The expectation of multiple rate cuts reflects the policymakers' confidence that they will not reignite inflation.

The Producer Price Index (PPI) for July, released on Tuesday, showed only a 0.1% rise in producer prices, below market expectations. This prompted warnings from some economists, such as Stephen Stanley, who noted the presence of volatile factors in the data, while Paul Ashworth argued that the report was "not as optimistic as it appears." Economist Lauren Henderson from Chicago's Stifel, Nicolaus & Co. also pointed out the mixed details within the report. Additionally, Fed Governor Michelle Bowman expressed caution towards rate cuts over the weekend, citing the ongoing risk of inflation.

Despite the PPI report indicating some easing of inflation pressures, Henderson stated that she and her team are still waiting for more data. Contrary to the general market view, they expect the Fed to maintain its current policy at the September meeting until they see Wednesday's CPI data and the PCE data at the end of the month. Henderson is more inclined to support Bowman's perspective, believing that inflation risks remain, and she anticipates the first rate cut might not occur until the fourth quarter.

The Consumer Price Index (CPI) for July, set to be released on Wednesday, is expected to show an annual inflation rate remaining around 3%, with core inflation slightly declining to 3.2%. The Federal Reserve will provide more policy clues at next week's Jackson Hole symposium, where Chair Powell will have the opportunity to comment before more data releases.

The Fed's most closely watched inflation indicator, the Personal Consumption Expenditures (PCE) index, will be released on August 30, followed by the CPI report for August on September 11, just a week before the Fed's potential first rate cut.

Henderson mentioned that she remains concerned about the three consecutive months of inflation data exceeding expectations in the first quarter. She pointed out that the Fed's track record for achieving a soft landing is not ideal, having succeeded only once in the mid-1990s. However, she does not rule out the possibility that the Fed could lower rates and still tame inflation in this cycle.

The data in the coming weeks will be crucial as traders are convinced that the Fed will begin easing policy next month, with the only suspense being whether the rate cut will be 25 basis points or larger. Economists expect both the annual inflation rate and core inflation rate in the July CPI report to be above the Fed's 2% target.

Monetary Policy Analytics economist Derek Tang believes the key question for both the Fed and the market now is, "Do you believe inflation will continue to fall? If so, then rate cuts will come at no cost and provide insurance against a recession."

Tang also noted that if inflation stagnates, the Fed can still slow the pace of rate cuts, which is not too bad a result. However, if inflation rises again, the Fed might make a mistake by cutting rates, complicating the situation further.

Even so, Tang stated that rate cuts might still be a price the Fed officials are willing to pay, especially if it means saving economic expansion and avoiding a recession. However, more potential supply shocks in the future could make inflation more volatile, necessitating a reevaluation of the Fed's 2% inflation target.

The first half of this year showed that even without actual Fed action, mere expectations of rate cuts could have an impact. For example, the stock market rally in May was believed to have created a wealth effect, boosting consumer demand and making the task of containing inflation more difficult.

Although the CPI remained flat in May and provided much good news about inflation, the Fed has been cautious for several months about cutting rates too quickly, stating that more confidence and data support are needed before taking action.

Michael Reynolds, vice president of investment strategy at Glenmede, said, "We believe the Fed is very focused on the risk of cutting rates too quickly. They are waiting for the two sets of CPI inflation data before the September meeting. If these data show improvement in inflation, policymakers will have room to start cutting rates."

Reynolds added, "The Fed gradually returning to a neutral rate level is a sustainable path. Although we do not expect a recession, we must closely watch labor market data as the situation could change rapidly."

On Tuesday, U.S. Treasury yields hit their lowest level since August 5, with the 2-year yield falling to 3.943%. All three major U.S. stock indices closed higher.

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