What the latest inflation data says about the Fed's rate cut

Inflation data released on Wednesday gave economists and investors the latest indication that the U.S. Federal Reserve could begin cutting interest rates next month.

The debate among Fed observers has evolved from whether Prices will be reduced to how soon and deeply the cuts will be. With inflation apparently under control, attention is turning to the possibility that a failure to cut interest rates sharply could seriously damage the economy, especially given recent data showing a weakening labor market.

“In a not-so-subtle shift, the market has moved from concern about inflation to concern about economic growth,” wrote Chris Zaccarelli, chief investment officer of the Independent Advisor Alliance. “The biggest change in the Fed's plans is likely to be the pace of the cuts.”

Fed officials, whose dual mandate is to promote price stability and maximum employment, have also expressed concern about deteriorating labor market conditions amid easing inflation, but have not committed to cutting interest rates.

Fed waits for further data

Fed Chairman Jerome Powell and his colleagues have said that interest rate cuts are possible as early as the next meeting of the Federal Open Market Committee in mid-September. However, everything depends on what the data looks like by then.

To bring inflation closer to the Fed's annual target of 2 percent, the committee has kept the influential benchmark interest rate in a range of 5.25 percent to 5.5 percent for more than a year, driving up the cost of auto loans, mortgages and other credit. The July consumer price report released Wednesday showed that annual inflation fell below 3 percent for the first time in three years.

Diane Swonk, chief economist at KPMG, said lower inflation and a change in the labor market “strengthen the argument for a half-percent rate cut in September to ensure we avoid a full-blown recession.”

Not all Fed observers agree that such a deep cut is necessary immediately.

“Nothing in today's CPI report rules out a Fed rate cut in September, but it doesn't exactly scream a panicked 50 basis point cut either,” wrote Scott Anderson, chief U.S. economist at BMO Capital Markets.

According to CME Group's FedWatch tool, which forecasts interest rate moves based on fed funds futures trading data, traders are pricing in a 37 percent chance that the Fed will cut interest rates by 50 basis points to a range of 4.75 percent to 5 percent at the September meeting. That's a sharp decline from earlier last week, when traders were forecasting a nearly 100 percent chance that the Fed could cut interest rates by 50 basis points and even call an emergency meeting after a surprisingly weak July jobs report.

Officials could soon provide clarity

Some central bankers still appeared unsure on Tuesday whether they would cut interest rates and demanded further data before committing to rate cuts.

It remains to be seen whether Wednesday's report is enough, and investors will likely turn their attention to upcoming remarks from the Federal Reserve for answers. Later this week, Federal Reserve Bank of St. Louis President Alberto Musalem and his counterpart in Philadelphia, Patrick Harker, are scheduled to speak.

Economists and investors are especially eager to hear more from Fed Chairman Powell, who is scheduled to speak at the Fed's annual economic symposium in Jackson Hole, Wyoming, on August 23.

Before the next FOMC meeting, officials will also get another important insight into the health of the labor market as well as several inflation indicators with the release of the August employment report on September 6.