The week's two most important inflation reports will help decide the size of the Fed's interest rate cut

The Federal Reserve will take a final look at inflation numbers this week before it soon determines the extent of a widely expected interest rate cut.

On Wednesday, the U.S. Department of Labor's Bureau of Labor Statistics will release its consumer price index for August. A day later, the BLS will release its producer price index, also for August. This index is used as an indicator of costs at the wholesale level.

Whether the Fed will cut rates when it concludes its next meeting on September 18 is virtually a done deal. The only question is by how much. Friday's jobs report provided little clarity on that question, so hopefully the CPI and PPI readings will provide clarity.

“Inflation data has taken a back seat to labor market data in terms of its influence on Fed policy,” Citigroup economist Veronica Clark said in a note. “But with markets — and likely Fed officials themselves — divided over the appropriate size of the first rate cut on Sept. 18, August's consumer price index data could remain an important factor in the upcoming decision.”

The Dow Jones consensus forecast calls for the consumer price index to rise by 0.2%, both for the headline index and for the core index, which excludes volatile food and energy products. On an annual basis, this would equate to inflation rates of 2.6% and 3.2%, respectively. The producer price index is also expected to rise by 0.2%, both for the headline index and for the core index. Fed officials generally place more emphasis on the core index, as it is a better indicator of longer-term trends.

At least for the consumer price index, the readings are not particularly close to the Fed's long-term target of 2%. However, there are a few important caveats to keep in mind.

First, although the Fed keeps an eye on the consumer price index, it is not its main measure of inflation. That would be the Commerce Department's personal consumption expenditures price index, which last put the inflation rate at 2.5% in July.

Second, policymakers are almost as concerned about the direction of the trend as the absolute value, and the trend in recent months has been toward a significant moderation in inflation. In terms of headline prices in particular, the 12-month CPI forecast for August would imply a decline of 0.3 percentage points from July.

Finally, Fed officials' focus has shifted from a strict effort to contain inflation to growing fears about the state of the labor market. Hiring has slowed significantly since April. Average monthly gains in nonfarm payrolls have fallen to 135,000 from 255,000 in the previous five months, and job openings have also declined.

As the focus is increasingly on the labor market, expectations have also risen that the Fed will begin cutting interest rates. The key interest rate is currently between 5.25 and 5.50 percent.

“The August consumer price index report should show further progress in bringing the inflation rate down to the Fed's 2.0 percent target,” wrote Dean Baker, co-founder of the Center for Economic and Policy Research. “Barring extraordinary surprises, there should be nothing in this report that would deter the Fed from cutting interest rates, perhaps even by a significant amount.”

However, markets seem to have come to terms with the Fed's slow start.

According to CME Group's FedWatch, futures prices on Tuesday suggest there is a 71 percent chance that the Federal Reserve's interest-rate-setting Open Market Committee will begin its easing campaign with a quarter-percentage-point cut, compared with just 29 percent for a more aggressive half-percentage-point cut.

However, some economists believe this may be a mistake.

Samuel Tombs, chief U.S. economist at Pantheon Macroeconomics, points to the overall decline in hiring combined with significant downward revisions to employment data from previous months. He says the “summer slowdown is likely to be even more pronounced in a few months” and that the downward trend in hiring “will continue for much longer.”

“We are therefore disappointed – but not surprised – that FOMC members, speaking after the jobs report but before the pre-meeting blackout period, are still leaning toward a 25 percent target. [basis point] “We will expect interest rate easing this month,” Tombs said in a note on Monday. “But at the November meeting, when we have two more employment reports in hand, the case for rapid rate cuts will be overwhelming.”

While market prices suggest that cuts will be slow to materialise in September, a half-percentage point cut is expected in November and there may be another such reduction in December.