Expected Below Target US Consumer Prices Also Suggest "5% Interest Rate Must Be Maintained"... Oil and Services Still 'Sticky' (Comprehensive)

Last month, when the US Consumer Price Index (CPI) inflation rate once again fell short of expectations, Wall Street expressed relief, calling it "the right direction for disinflation." There is speculation that the Federal Reserve's (Fed) prolonged tightening cycle, which has lasted over a year to curb inflation, will soon come to an end. However, caution remains as oil prices have recently surged again. Some also argue that even if inflation cools down, high interest rates in the 5% range must be maintained for a while.

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US CPI Rises 3.2% in July, Below Expectations... Over 90% Probability of Rate Hold in September

According to the US Department of Labor on the 10th (local time), the July CPI rose 3.2% year-on-year. This figure slightly missed Wall Street’s forecast of 3.3%. Compared to June’s 3.0% increase, which was the lowest in over two years, the rise was steeper again, but the overall trend indicates a continued easing. The July CPI increased 0.2% month-on-month, meeting expectations. The core CPI, which excludes volatile energy and food prices, rose 4.7% year-on-year, down from 4.8% the previous month. Month-on-month, it increased by 0.2%.

The Department of Labor explained that over 90% of last month’s CPI increase was due to housing costs, including rents. Housing costs rose 0.4% month-on-month and 7.7% year-on-year. Wall Street expects housing costs to soon turn downward in the indicators, considering there is at least a six-month lag before rent price declines are reflected in the CPI. Prices of used cars and trucks, which had fueled inflation last year, fell 1.3% month-on-month, a sharper decline than the previous month’s 0.5%. Year-on-year, they dropped 5.6%. Despite the recent surge in oil prices, energy prices rose only 0.1% over the month.

Mary Daly, President of the Federal Reserve Bank of San Francisco, described the CPI report in an interview with Yahoo as "mostly as expected and good news." Shima Shah, Chief Global Strategist at Principal Asset Management, also said, "A case is being made for the Fed to hold rates in September," adding, "Inflation is moving in the right direction." Anna Wong, an economist at Bloomberg Economics, focused on the core CPI, stating, "The pace aligns with the 2% inflation target. The Fed is expected to hold rates steady through the end of the year."

The unemployment data released that morning also supported the rate-hold outlook by showing a continued increase for the second consecutive week. According to the US Department of Labor, new unemployment claims for the week of July 30 to August 5 rose by 21,000 to 248,000, exceeding the market expectation of 230,000. The Fed has previously stated that for the tightening cycle to end, growth must remain below trend and labor market overheating must cool down. Michael Contopoulos of Richard Bernstein Advisors noted, "The sharp rise in unemployment claims today is noteworthy," adding, "Although slow, the ongoing weakening of the labor market alongside continued inflation deceleration is no coincidence."

The market also strongly favors a rate hold. According to the Chicago Mercantile Exchange (CME) FedWatch tool, the federal funds (FF) futures market on the morning of the report reflected over a 90% probability that the Fed will hold rates at the next Federal Open Market Committee (FOMC) meeting in September. This was an increase from the previous day’s 86% probability, strengthened after the CPI release. Although the Fed’s June dot plot indicated the possibility of one more rate hike this year, investors are betting on no further increases. There are three remaining FOMC meetings this year: September, November, and December.

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"Still Much to Do" and Calls to Maintain 5% Range Interest Rates Continue

However, cautious voices emphasize that there is still a long way to go. President Daly said, "This is not a data point that says victory in the fight against inflation is ours," stressing, "There is still much to do. The Fed is committed to achieving the 2% inflation target." David Russell, Vice President at TradeStation, also noted that while the CPI report is good news for the market, there remains a split within the Fed between hawks who advocate further hikes and doves who support holding rates steady.

Therefore, the key will be the signals Fed Chair Jerome Powell sends at the Jackson Hole forum later this month. With over a month remaining until the September FOMC, many inflation and employment indicators still need to be reviewed. Sam Milette, strategist at Commonwealth Financial Network, said, "Today’s CPI supports investors’ calls for a pause in rate hikes at the September FOMC, but the Fed will continue to monitor data before making a final decision." Greg McBride, Chief Financial Analyst at Bankrate, also pointed out, "We need to see more evidence that inflationary pressures are easing."

The July CPI report confirmed that the service price inflation, which Powell has been concerned about, remains sticky. Various economic indicators also showed stronger-than-expected levels, acting as upward pressure on inflation. Particularly, the recent upward trend in oil prices is a variable. The Wall Street Journal (WSJ) reported that this rise in oil prices could pose a burden on the Fed as it nears the end of its tightening cycle. Over the past three months, wholesale diesel prices surged 31%, jet fuel prices rose 33%, and gasoline prices jumped 18%.

The Fed’s preferred inflation gauge, the core Personal Consumption Expenditures (PCE) price index, excludes volatile food and energy costs. However, rising oil prices can indirectly push up costs across all sectors of the economy. As a result, it is expected to be difficult for the Fed to shift policy toward rate cuts in the near future. Currently, US interest rates are at their highest level in 22 years, ranging from 5.25% to 5.5% annually.

There are also additional voices calling for major countries, including the US, to maintain high interest rates in the 5% range for some time. Jim O’Neill, Senior Advisor at Chatham House and former Chairman of Goldman Sachs Asset Management, appeared on CNBC and said, "Major advanced economies will need to keep rates at around 5% longer than markets expect," explaining, "If inflation is to be permanently stabilized, interest rates must maintain a kind of positive relationship with inflation." This contrasts with the rate futures market, which anticipates rate cuts next year. Shah, the strategist, said, "The still-high inflation levels show that the Fed is some distance from cutting rates," adding, "Disinflation will not be smooth, and some additional economic pain will be necessary before the 2% inflation target is confirmed."

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