Huachuang Zhang Yu: Conditions for a 50bp rate cut in September are not enough

Key Points

In July, the CPI met the Fed's expectations for anti-inflation, meeting the conditions for a rate cut in September. However, the current economic and financial situation does not yet support a 50bp rate cut. Especially in the financial markets, compared to the 50bp rate cuts in January 2001 and September 2007, the market volatility in the past two weeks has not been significant enough. Therefore, it is necessary to monitor whether the market volatility will evolve into a liquidity crisis in the short term in the future. The key indicators to track are: the correlation between stocks and bonds on the asset side, offshore liquidity of the euro and yen against the US dollar on the liability side, and the VIX index on the risk sentiment side. If these three indicators do not show signs of a crisis, the soft landing will gradually be confirmed, and the trading of recession or continuation will continue.

Report Summary

Expected CPI Data Supports Fed Rate Cut in September

The CPI in July was as expected, completely in line with market expectations. The overall CPI and core CPI rebounded slightly month-on-month, with the year-on-year readings continuing to decline due to base effects. The CPI year-on-year decreased from 3% to 2.9%, with an expectation of 3% (deviation due to rounding to the nearest decimal point); CPI month-on-month was 0.2%, compared to the previous -0.1%, with an expectation of 0.2%. Core CPI year-on-year decreased from 3.3% to 3.2%, with an expectation of 3.2%; core CPI month-on-month was 0.2%, compared to the previous 0.1%, with an expectation of 0.2%.

Structural Rebound in Sub-items for the Month: Firstly, gasoline prices (0%, compared to -3.7% previously) stopped falling, eliminating the drag from the energy sector; secondly, rental growth rates rebounded, with increases in owner's equivalent rent (0.36%, compared to 0.28%) and primary residence rent (0.49%, compared to 0.26%); thirdly, entertainment services (0.4%, compared to -0.1%), hotel accommodation (0.2%, compared to -2.5%), and transportation services (0.4%, compared to -0.5%) related to travel and vacation showed high volatility, driving the super core service prices (0.21%, compared to -0.05%) from decline to increase. In addition, influenced by the decline in used car prices (-2.3%, compared to -1.5%), the trend of core goods deflation continued.

July CPI also meets the Fed's expectations, providing support for a rate cut in September. At the July FOMC meeting, Powell stated that "if the inflation process broadly meets expectations and the labor market maintains its normalization trend, a rate cut in September may be possible." What kind of inflation process meets the Fed's expectations? The Fed believes that the anti-inflation progress was good in the second half of last year and the second quarter of this year, with some setbacks in the first quarter of this year. The average month-on-month core CPI was 0.27% in the second half of last year, 0.37% in the first quarter of this year, and 0.17% in the second quarter of this year, with July at 0.17%. From the data perspective, July should also meet the Fed's anti-inflation expectations and the conditions for a rate cut in September.

However, the conditions for a 50bp rate cut in September are not sufficient

Due to the unexpectedly weak non-farm payroll data in July, market expectations of a "recession" have increased. Since early August, the probability of a 50bp rate cut in September priced in the futures market has reached as high as 85%, still at 53% before the CPI announcement, and dropped to 36% after the CPI announcement We believe that the current economic and financial situation does not support a 50bp rate cut:

Firstly, from the perspective of the labor market, the July data contains noise, with hurricane weather exerting some drag on non-farm employment and the unemployment rate. The upward trend in the unemployment rate is also driven by supply growth, and the Sam rule for the unemployment rate needs to be triggered continuously for more than 3 months to be meaningful. After the employment data was released, public statements from Fed officials also indicated that the overall U.S. job market remains robust, and Fed decisions will not be based on a single data point.

Secondly, from the financial market perspective, historical experience indicates that the current market volatility is not sufficient to warrant a 50bp rate cut. Since the 1990s, during the rate cut cycles in 2001-2003 and 2007-2008, the Fed chose to cut rates by 50bp on the first occasion, in January 2001 and September 2007 respectively. However, both of these instances were accompanied by sustained significant market volatility, a condition that may not be met at present. In the 3 months prior to the 50bp rate cut in January 2001 and September 2007, the following occurred: 1) a significant decline in U.S. stocks (10-15% drop) with difficulty in recovering lost ground; 2) the VIX index, which reflects market volatility, fluctuated higher; 3) a noticeable tightening of financial conditions index. Currently, in early August, U.S. stocks experienced a sharp decline but quickly rebounded, the VIX index surged but soon returned to its pre-surge low, and the financial conditions index remains very loose with no signs of tightening.

Lastly, the economic fundamentals currently do not support market expectations of a recession. The robust balance sheets and wealth effect defenses of the private sector, high government spending, and the resilience of corporate investment under industrial policies continue to support the economy. Importantly, there has been no collapse of "excessive wealth" (significant drops in stock and housing prices), so a true "recession" still lacks a viable path to realization.

Report Content

I. July CPI Supports Fed Rate Cut in September

(I) As-expected CPI Supports September Rate Cut

In July, U.S. CPI inflation was in line with market expectations, with both overall CPI and core CPI showing a slight rebound on a month-on-month basis, while their year-on-year readings continued to decline. The CPI year-on-year decreased from 3% to 2.9%, with an expectation of 3% (deviation due to rounding); CPI month-on-month was 0.2%, compared to the previous -0.1%, with an expectation of 0.2%. Core CPI year-on-year decreased from 3.3% to 3.2%, with an expectation of 3.2%; core CPI month-on-month was 0.2%, compared to the previous 0.1%, with an expectation of 0.2%.

The structure of this month's month-on-month rebound is as follows: First, gasoline prices (0%, previous -3.7%) stabilized, eliminating the drag from the energy component; Second, rental growth rates showed some recovery, with increases in owner's equivalent rent (0.36%, previous 0.28%) and primary residence rent (0.49%, previous 0.26%); Third, entertainment services (0.4%, previous -0.1%), hotel accommodation (0.2%, previous -2.5%), transportation services (0.4%, previous -0.5%), and other high-volatility items related to travel and vacation drove the super core services prices (0.21%, The core commodity deflation trend continued to rise in July (+0.17%, previous value -0.05%) despite the impact of the used car market (-2.3%, previous value -1.5%).

We believe that the July CPI also meets the Fed's expectations, providing support for a rate cut in September. During the July FOMC meeting, Powell mentioned that "if the inflation process broadly meets expectations, the labor market maintains a normalization trend, a rate cut may be possible in September." What kind of inflation process meets the Fed's expectations? The Fed believes that the progress of core inflation was good in the second half of last year and the second quarter of this year, with some setbacks in the first quarter of this year. The average month-on-month core CPI was 0.27% in the second half of last year, 0.37% in the first quarter of this year, and 0.17% in the second quarter of this year. In July, it was 0.17%. Based on the data comparison, the July data should also meet the Fed's expectations for inflation and the conditions for a rate cut in September.

(II) However, the current situation does not support a 50bp rate cut

Due to the weaker-than-expected non-farm payroll data in July, market expectations of a "recession" have increased. Since early August, the probability of a 50bp rate cut in September in the futures market has reached as high as 85%, still at 53% before the CPI announcement, and dropped to 36% after the CPI announcement.

We believe that the current dynamics in the labor market and financial markets do not support a 50bp rate cut.

Firstly, looking at the labor market, there is noise in the July data, with hurricane weather affecting non-farm employment and the unemployment rate. The upward trend in the unemployment rate is also driven by significant supply growth. The rule of thumb for the unemployment rate also needs to trigger for more than 3 consecutive months to be meaningful. After the employment data was released, public statements from Fed officials indicated that the overall U.S. labor market remains robust, and Fed decisions are not based on single data points.

Secondly, from the perspective of the financial markets, historical experience shows that the current market volatility is not enough to support a 50bp rate cut by the Fed. Since the 1990s, during the rate cut cycles in 2001-2003 and 2007-2008, the Fed chose to cut rates by 50bp for the first time in January 2001 and September 2007. However, both times were accompanied by sustained significant market volatility, a condition that may not be met at present. In the 3 months before the initial 50bp rate cut in January 2001 and September 2007, there were: 1) significant declines in U.S. stocks that were difficult to recover from; 2) the VIX index, which reflects market volatility, fluctuated higher; 3) a significant tightening of financial conditions. Currently, U.S. stocks plummeted in early August but quickly rebounded, the VIX index surged but quickly returned to pre-surge levels, and financial conditions remain very accommodative without signs of tightening.

Lastly, the economic fundamentals currently do not support expectations of a U.S. recession. The robust balance sheets and wealth effect defenses of the private sector, high government spending, and the resilience of corporate investment under industrial policies still support the economy. Importantly, there is no collapse of "excessive wealth" (sharp declines in stock and housing prices), making it difficult for a true "recession" to materialize ("From "Excessive Savings"

II. Review of U.S. CPI Data in July

Inflation in July continued to cool down, in line with market expectations. The year-on-year CPI dropped from 3% to 2.9%, with an expectation of 3% (the deviation in expectations comes from rounding issues). Core CPI year-on-year decreased from 3.3% to 3.2%, with an expectation of 3.2%; the annualized six-month change in core CPI dropped from 3.3% to 2.8%, marking a third consecutive monthly decline. Year-on-year core goods prices decreased from -1.8% to -1.9%, while rent inflation dropped from 5.2% to 5.1%, and super core service prices fell from 4.7% to 4.5%.

Overall inflation breadth continued to decline. The proportion of CPI sub-items with a year-on-year increase of over 2% decreased from 42% to 35.2%, with an average of 51.5% from 2000 to 2009, 36.8% from 2010 to 2019, and an average of 74% from 2021 to the first half of 2023. The proportion of core CPI sub-items with a year-on-year increase of over 2% decreased from 44.9% to 43.1%, with an average of 49.6% from 2000 to 2009, 37.8% from 2010 to 2019, and an average of 72.2% from 2021 to the first half of 2023.

Looking at the seasonally adjusted month-on-month data, it is in line with market expectations. CPI rose by 0.2%, compared to the previous -0.1%, with an expectation of 0.2%; core CPI also rose by 0.2%, compared to the previous 0.1%, with an expectation of 0.2% In non-core items, energy prices remained unchanged month-on-month, with gasoline prices (0%, previously -3.7%) flat, gas prices (-0.7%, previously 2.4%) slightly down, and fuel prices (1.9%, previously -2.5%) up. Food prices rose by 0.2%, maintaining a normal level. Prices for dining out (0.2%, previously 0.4%) saw a decrease in growth rate, while prices for household food (0.1%, previously 0.1%) rose moderately.

In core items, both rent and super-core services rebounded month-on-month, while core commodity prices saw a larger decline.

1) Core commodity prices fell by 0.3%, previously falling by 0.1%, mainly dragged down by automobiles. Looking at categories, prices of used cars (-2.3%, previously -1.5%) saw an expanded decline, prices of clothing and entertainment goods turned from rising to falling, prices of furniture and household goods, education and communication goods turned from falling to rising, while prices of other commodities continued to rise moderately. The scope of core commodity deflation slightly expanded, with 15 out of 29 major commodities falling this month, compared to 14 last month, 13 in 2023, 9 in 2022, and 17 from 2015 to 2019.

2) Rental growth rate rebounded. Equivalent rents for landlords (0.36%, previously 0.28%) and primary residence rents (0.49%, previously 0.26%) saw a rebound in growth rate, while away-from-home accommodation prices (0.2%, previously -2%) turned from falling to rising.

3) Prices of super-core services rose by 0.21%, compared to a 0.05% decline last month, mainly driven by prices of travel and vacation-related services. Entertainment services (0.4%, previously -0.1%), hotel accommodation (0.2%, previously -2.5%), and transportation services (0.4%, previously -0.5%) all turned from falling to rising, while healthcare services (-0.3%, previously 0.2%) turned to a decline, and prices of education and communication services (0.2%, previously 0%), utilities (0.5%, previously 0.2%), and personal services (0.3%, previously 0.9%) rose.

Authors: Zhang Yu (S0360518090001), Fu Chunsheng; Source: Yiyu Zhongde; Original Title: "Conditions for a 50bp Rate Cut in September are Insufficient - Analysis of U.S. CPI Data for July"