After tonight, there may be major changes at the Federal Reserve!

The news on Tuesday regarding US data is favorable for inflation, and investors are hoping for a better situation when the Labor Department releases the Consumer Price Index (CPI) report for July on Wednesday.

"If the CPI data announced tonight is equally ideal, it will confirm that the surge in prices at the beginning of the year was either a random event or the final struggle of inflation, possibly indicating that the Federal Reserve may be able to shift its focus to other economic challenges, such as the slowdown in the labor market," said Jim Baird, Chief Investment Officer at Plante Moran Financial Advisors. "Currently, the inflation pressure we see has significantly dissipated. Inflation is hardly a problem now. It is widely believed that the worst period is over."

Like others on Wall Street, Baird expects the Federal Reserve to shift its focus from tight policies to combat inflation to a more accommodative stance in September to prevent a potential weakening in the job market.

Although consumers and business owners continue to express concerns about high prices, the trend has indeed shifted. The July Producer Price Index (PPI) report released on Tuesday helped confirm the optimistic sentiment that the high inflation figures that surged since 2021 and peaked again in early 2024 have become a thing of the past.

The PPI report, considered an indicator of wholesale inflation, showed a mere 0.2% increase in prices in July, about 2.2% higher than a year ago. This figure is now very close to the Federal Reserve's 2% target and indicates that the market's urge to start cutting interest rates is largely in line with expectations.

Economists surveyed by Dow Jones expect that the CPI will also show a 0.2% increase in both overall inflation and core inflation (excluding food and energy) on a month-on-month basis, but the 12-month growth rates are expected to be 3% and 3.2%—significantly lower than their mid-2022 peaks but still far from the Federal Reserve's 2% target.

However, investors are still anticipating the Federal Reserve to start cutting interest rates at the September meeting, considering that inflation is weakening and the labor market is also weakening. The unemployment rate has risen to 4.3%, an increase of 0.8 percentage points from the same period last year, triggering a classic recession signal known as the "Sam Rule."

Baird said, "Given the relative weakness in the labor market that people are focusing on, given the rapid decline in inflation, and I expect inflation to continue to decline in the coming months, if the Federal Reserve does not quickly shift to accommodative policies, it would be a surprise, possibly at the September meeting. If they don't do so at the September meeting, the market won't treat them kindly."

Concerns about the Federal Reserve's Slow Response

The initial claims for unemployment benefits briefly rose at the beginning of the week, along with other weak economic indicators, briefly leading some in the market to seek emergency rate cuts.

Although this sentiment has subsided, concerns remain about the Federal Reserve's policy easing being too slow, similar to the slow pace of rate hikes when inflation began to rise Another mild inflation report will "make the Fed completely at ease, they can shift their focus from inflation to labor," said Tom Porcelli, Chief U.S. Economist for PGIM Fixed Income. "They could have shifted their attention from inflation to labor several months ago."

Cracks are appearing in the labor market backdrop.

Amid the dual reality of declining inflation and rising unemployment, the market is pricing in a "definite rate cut" by the Fed at the September 17-18 meeting, the only remaining question is how large the rate cut will be.

According to calculations by the Chicago Mercantile Exchange Group, futures pricing is roughly divided into a 25 or 50 basis point rate cut in September, with a high likelihood of a full percentage point cut by the end of the year.

However, futures pricing has deviated from reality for most of the time. Traders initially expected the Fed to quickly cut rates at the beginning of the year, then converged to only expecting one or two rate cuts, until recently another extreme volatility in the opposite direction emerged.

"I am as curious as others about the CPI report on (Wednesday), but I believe the Fed will not change its stance unless there are truly exceptional circumstances, focusing on labor and seriously considering a rate cut in September," Porcelli said. "They should take proactive action to start cutting rates. I can easily make a case for the Fed to cut rates by 50 basis points, as I believe they should have already cut rates. But I don't think they will do so, they will modestly start."