The market just got the next clue about inflation. Here’s what it means for the Fed.

With the next Federal Reserve meeting just days away, the market has skimmed over any relevant economic data for clues about the current state of inflation and the economy as the Fed prepares to cut interest rates for the first time since early 2020 .The August jobs report sent shockwaves through the market last Friday after it showed the US economy added fewer jobs than expected. Last week, S&P 500 posted its worst week of losses since March 2023.

But that already feels like a lifetime ago after the US Bureau of Labor Statistics recently released the August reading of the consumer price index for all urban consumers. The market just got the next clue about inflation. Here’s why it’s important and what it means for the Fed.

The Fed may cut rates, but by how much?

Data in recent months have indicated that the economy is cooling and inflation is slowing. US nonfarm payrolls added 142,000 jobs in August, 19,000 below consensus. Unemployment fell marginally to 4.2%. Meanwhile, Fed Chairman Jerome Powell has all but indicated that the Fed will begin cutting interest rates at its next meeting, saying at the Fed’s August summit in Jackson Hole that “the time has come for policy to adjust.”

The big question is how much the Fed will cut the federal funds rate, which is currently in the 5.25%-5.50% range. In one camp, investors believe the economy is still holding up pretty well, while consumer prices have eased again after rising last year. This camp believes the Fed can project a soft landing and therefore only needs to cut by a quarter of a point at its meeting.

In another camp, investors believe the Fed’s aggressive rate hike campaign over the past two years, which has included numerous rate hikes of 75 basis points, has probably gone too far and will soon lead to a deterioration economy and some kind of moderate to severe recession. This camp is more in favor of a half-point increase to ensure the economy doesn’t slow down too much when the real pain from all the rate hikes finally hits.

The latest hint on inflation came from Wednesday morning’s CPI data, which showed consumer prices rose 0.2% in August, in line with consensus, and rose 2.5% year-on-year , slightly below consensus. Interestingly, core inflation, which excludes food and energy, rose 0.3% in August, slightly higher than consensus, although the overall core inflation number was in line with expectations of 3.2%.

Housing costs remain a concern and rose 0.5% in August, the biggest monthly increase since January. Transportation services also rose 0.9 percent in August, the biggest monthly increase since April.

CPI trend chart by author. Data source: Federal Reserve Economic Data. * = seasonally adjusted numbers.

What does the data mean?

The CPI shows that inflation is falling and heading towards the Fed’s 2% inflation target. However, it is not such a surprising drop to suggest that demand is falling at an alarming rate – at least at the moment. Treasury yields rose following the report. So the data suggests the Fed will cut the federal funds rate by a quarter point next Wednesday instead of half a point.

According to FedWatch, a tool that analyzes federal funds rate futures prices, 85% of those traders expect a quarter-point cut, while 15% expect a half-point increase (as of the morning of the 11 September). A day earlier, the split was 66% in favor of a quarter-point cut and 34% in favor of a half-point cut.

While I can’t predict the future of the economy, I think a quarter point cut is the better case scenario for the market because a half point cut probably means the economy is in more trouble and could go into a recession. Jumbo rate cuts and increases also lead to more uncertainty and volatility, which can be difficult to navigate.