The CPI is Not Perfect, but it is Good Enough for Stocks to Waver

Stocks experienced fluctuations following a recent rally, as an in-line U.S. inflation report did little to significantly impact expectations regarding the Federal Reserve's upcoming policy decisions. While most major sectors within the S&P 500 showed gains, the index itself struggled to maintain momentum after a four-day surge that marked its best performance of 2024. Treasury yields slightly decreased, and swap markets continued to anticipate the Federal Reserve's first rate cut in September. Meanwhile, the U.S. dollar moved towards its lowest level since March.

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The inflation report reinforced the ongoing trend of disinflation, albeit at a moderate pace, and brought a relative sense of calm to markets still feeling the effects of last week’s significant downturn. With the job market showing signs of weakening, the consensus is that the Federal Reserve will begin lowering interest rates next month, with the magnitude of the cut likely to depend on forthcoming economic data.

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Chris Larkin of E*Trade from Morgan Stanley noted that while the report may not have been as encouraging as the previous day's Producer Price Index (PPI) data, it was unlikely to cause major disruptions in market expectations. "The main question now is whether the Fed will opt for a 25 or 50 basis point rate cut next month. If the majority of data over the next five weeks indicates a slowing economy, the Fed may choose to cut more aggressively," Larkin commented.

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Krishna Guha of Evercore echoed this sentiment, stating that while the July Consumer Price Index (CPI) was not perfect, it was sufficiently aligned with the Fed’s preferred inflation measure to avoid major concerns. Guha emphasized that the Federal Reserve has shifted away from being solely data-driven and is now considering the broader economic outlook and balance of risks, particularly focusing on employment. "This is now a labor data-first Fed, not an inflation data-first Fed, and the incoming labor data will determine how aggressively the Fed pulls forward rate cuts," Guha explained.

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The S&P 500 hovered near the 5,440 mark, while a Bloomberg gauge tracking the "Magnificent Seven" mega-cap stocks dipped by 0.6%. Alphabet Inc. saw a 3.5% decline following a Bloomberg News report suggesting that the Department of Justice is considering a bid to break up Google. Financial shares outperformed, while the Russell 2000 index of smaller firms fell by 0.6%. Additionally, Treasury 10-year yields decreased by three basis points to 3.81%.

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The core CPI, which excludes volatile food and energy prices, increased by 3.2% in July compared to the previous year, marking the slowest pace since early 2021. On a monthly basis, the core CPI rose by 0.2%, a slight increase from June’s unexpectedly low reading. Economists view the core CPI as a more accurate indicator of underlying inflation than the overall CPI.

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This CPI report follows a softer-than-expected PPI reading, which had led markets to price in a more pronounced disinflation trend, according to Florian Ielpo of Lombard Odier Investment Managers. Ielpo pointed out that the report presents two challenges: it provides little new information to guide the Federal Reserve's future decisions, aside from possibly supporting a rate cut due to concerns about the job market. Additionally, there is a risk that markets may have "over-anticipated" the report’s implications. "By all means, this is a mixed report," Ielpo concluded.

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Seema Shah of Principal Asset Management noted that the CPI data removes any remaining inflationary hurdles that could have prevented the Fed from beginning its rate-cutting cycle in September. However, Shah also suggested that the data does not indicate an urgent need for a 50 basis point cut. Rajeev Sharma of Key Wealth echoed this view, stating, "With today’s CPI print aligning closely with consensus expectations, this report supports the disinflation trend and suggests a Fed that is likely to cut rates in September. However, this CPI print does not strongly advocate for a 50-basis point rate cut. A 25-basis point cut next month is more probable."

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In summary, while the recent CPI report confirmed the ongoing trend of disinflation and calmed markets, it did not significantly alter the outlook for Federal Reserve policy. Market participants continue to expect rate cuts, with the size of the cuts depending on future economic data, particularly labor market indicators. The Federal Reserve is likely to take a cautious approach, balancing the need to support the economy with the risks of reigniting inflation.

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