US inflation report sets up Fed rate cut in September

The soft reading continues a months-long trend of moderating inflation — a sign that the inflationary pressures that drove one of the most aggressive policy-tightening cycles in history have finally eased.

“Today’s inflation data provides further support for the Fed’s aggressive rate cuts starting in September,” says Morningstar Chief Economist Preston Caldwell. While he cautions that monthly inflation data may remain volatile, he says the risk of a further economic contraction is starting to outweigh the risk of another rise in inflation.

Some analysts have already suggested the Fed waited too long to cut rates, pointing to rising unemployment and the risk of a recession. While that’s not Caldwell’s base case, he says a persistent economic downturn would help solve the inflation problem.

Key statistics from the July CPI report

• CPI rose 0.2% for the month after falling 0.1% in June
• Core CPI rose 0.2% after rising 0.1% in June
• CPI rose 2.9% year-on-year after rising 3.0% the previous month
• Core CPI rose 3.2% from a year ago after rising 3.3% in June

Used car prices help reduce inflation

Prices in the basic goods category fell 0.3 percent on a monthly basis in July, Caldwell said. This decline was largely driven by lower prices for new and used cars. He also points to the decline in clothing prices, which contributed to a 0.3% drop in non-durable goods prices for the month.

On the services side, Caldwell says a shrinking labor market and slowing wage growth are starting to weigh on prices. For example, restaurant inflation was 4.1% on an annualized basis in July, compared to its peak of 8.8% in March 2023. “With wage growth cooling to around 4%, there is room for inflation to fall and more so in areas like restaurants,” he adds.

Housing inflation is still high

Home inflation rose slightly to 0.38% in July from 0.23% in June. These shelter costs, which include rent and equivalent costs for homeowners, have been one of the biggest drivers of inflation over the past two years.

“On a year-over-year basis, shelter inflation is 5% and is solely responsible for keeping core inflation above the Fed’s 2% target,” Caldwell says. Without inflation, the Fed’s preferred measure of inflation would be at the 2% target, he explains.

Real-time data on shelter costs tends to lag CPI data, suggesting there is more room for shelter inflation to fall in the coming months. “The peak rent data strongly suggests that housing inflation should continue to moderate,” says Caldwell.

Will the Fed cut rates in September?

Amid some evidence that the economy is slowing, such as a rising unemployment rate, markets are virtually certain the Fed will cut rates at its September meeting.

Bond futures traders see a 56.5% chance of a 0.25% cut in the federal funds rate and a slightly lower chance of a 0.50% cut, according to CME’s FedWatch tool. Markets see a 43.20% chance that the fed funds target rate will fall to between 4.25% and 4.50% at the end of 2024, an across-the-board reduction of one percentage point.

Caldwell’s base case for September is a 0.25% cut, which would bring the target federal funds rate to a range of 5.00%-5.25%. “While the rising unemployment rate is raising alarm bells, other labor market indicators look more welcome,” he says. “Not to mention that economic activity continues to expand at a solid pace for now, although we expect a deceleration over the next year.”

In the long run, Caldwell says, “optimal monetary policy requires a significant reduction in the federal funds rate in the near term.” Markets seem to agree, with traders anticipating a 2% cut in the Fed’s target rate by the September 2025 meeting.