US Inflation Slowdown Supports Fed's Rate Cut This Year
The U.S. Consumer Price Index (CPI) for June rose by 3.0% year-on-year (previously 3.3%), and the core CPI increased by 3.3% year-on-year (previously 3.4%). Both figures have decelerated compared to the previous month and are below market expectations. This data is welcome as it indicates that U.S. inflation is further cooling down. These figures will also strengthen the Federal Reserve's motivation to cut interest rates within the year, although the timing of the rate cut is still to be confirmed.
Considering that the U.S. labor market remains robust, fiscal expansion is expected to accelerate in the second half of the year according to CBO estimates, and there is a suspicion of an overreaction to the "reaction function" of interest rate cuts in the market, our view on the timing of the rate cut is more cautious than the market. Without more compelling data, we maintain our baseline scenario of a rate cut in the fourth quarter.
Firstly, the deceleration of inflation in June is widespread, with both overall and core CPI showing signs of slowing down. Looking at the detailed items, the prices of new cars, used cars, furniture, home appliances, computers, and other goods continue to fall, which is partly due to improved supply chains and may also be influenced by the structural shift of consumer demand from goods back to services after the pandemic. Housing inflation has finally seen a "long-awaited" slowdown in month-on-month growth. The seasonally adjusted month-on-month growth rate of primary residence rent and owner's equivalent rent slowed from 0.4% to 0.3%, but due to a 2.5% month-on-month decline in hotel prices, the overall housing component growth rate was suppressed to 0.2%.
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The Federal Reserve's most closely watched non-housing core service inflation (supercore) slowed for the second consecutive month, with the month-on-month growth rate dropping from zero in May to -0.1% in June. Airfare prices fell further by 5.0% after a 3.6% decrease last month. The growth rates of hospital services, entertainment services, courier services, and other items also turned negative. The increase in immigrants entering the United States since last year has cooled the labor market, which has also played a role in reducing service inflation.
Secondly, this set of inflation data will strengthen the Federal Reserve's motivation to cut interest rates within the year, but the timing of the rate cut is still to be confirmed. Powell stated during his testimony in Congress this week that the U.S. labor market has cooled down and inflation has made progress, but a rate cut still requires "more good data"[1]. The latest inflation data released on July 11th is good data, so it will enhance the Federal Reserve's confidence in cutting interest rates.
However, there are still two months until the September FOMC meeting, during which there will be two more sets of inflation and employment data. We believe the Federal Reserve will observe more data before making a decision, rather than giving a premature easing guidance as at the end of last year, which ultimately backfired.
Thirdly, the U.S. labor market remains robust, and with fiscal expansion expected to accelerate in the second half of the year according to CBO estimates, it may once again suppress expectations for interest rate cuts. In terms of the labor market, the rise in the unemployment rate in June made the market worry about employment deterioration, thereby forcing the Federal Reserve to cut interest rates as soon as possible. However, we believe the main reason for the rise in the unemployment rate is that more people have entered the labor market, not because of layoffs by companies.
In other words, the rise in the unemployment rate is due to an increase in supply, not a significant deterioration in demand, so we believe there is a high probability that there will not be a "non-linear rise" in the unemployment rate. Additionally, the number of initial jobless claims for the week announced today unexpectedly fell to 222,000, a significant decrease of 17,000 from the previous week, indicating that the labor market remains healthy.
On the fiscal front, the U.S. Congressional Budget Office (CBO) has recently raised its forecast for the deficit ratio for the fiscal year 2024, from the initial forecast of 5.3% to 6.7%, an increase of 1.4 percentage points[2]. According to CBO's forecast, the total deficit for the fiscal year 2024 is about $1.9 trillion, equivalent to an average monthly deficit of about $159 billion.
Among them, the average for the first 8 months (from October 2023 to May 2024) is about $150 billion, a year-on-year increase of 3.2%, and for the last 4 months (from June to September 2024) it is about $178 billion, a year-on-year increase of 34.5%. This means that fiscal spending is expected to accelerate in the third quarter of this year, providing additional support for economic growth, and expectations for interest rate cuts may also be suppressed as a result.According to CME data, the market currently prices the probability of a rate cut in September at over 80%[3]. However, there are still employment and inflation data for July and August to be released before the September FOMC meeting, so there is still uncertainty. In fact, the market's "reaction function" to rate cuts has always been suspected of overreacting, as people always want to "get ahead" in rate cut trades.
At the beginning of this year, the market's pricing for a rate cut by the Fed in March once reached as high as 75%, and the pricing for the number of rate cuts for the whole year even reached 6 or 7 times, but in the end, none of them came true. In view of this, we believe that more data needs to be observed. If it is only based on the existing data, we still maintain the judgment that there will be one rate cut in the fourth quarter under the base case scenario.