US inflation report suggests Fed will cut interest rates in September

The moderate reading continues a trend of declining inflation that has been ongoing for several months – a sign that the inflationary pressures that led to one of the most aggressive cycles of monetary tightening in history have finally abated.

“Today's inflation data further supports the Fed's aggressive rate cuts starting in September,” said Preston Caldwell, chief U.S. economist at Morningstar. While he cautioned that monthly inflation data may remain volatile, he said the risk of a major economic downturn is beginning to outweigh the risk of a further rise in inflation.

Some analysts have already suggested that the Fed has waited too long to cut rates, citing rising unemployment and the risk of a recession. While that is not Caldwell's base case, he says a sustained economic slowdown would help solve the inflation problem.

Key statistics on the Consumer Price Index (CPI) in July

• The consumer price index (CPI) rose 0.2% during the month after falling 0.1% in June
• Core CPI rose 0.2% after growing 0.1% in June
• The Consumer Price Index (CPI) rose 2.9% year-on-year, after rising 3.0% in the previous month
• Core CPI rose 3.2% from a year earlier, after rising 3.3% in June

Used car prices help reduce inflation

Prices in the core goods category fell 0.3 percent on a monthly basis in July, Caldwell said. The decline was largely due to falling prices for new and used cars. He also pointed to falling clothing prices, which contributed to a 0.3 percent drop in prices for non-durable goods in the month.

On the services side, Caldwell says a cooling labor market and slowing wage growth are starting to affect prices. For example, inflation in the restaurant sector was 4.1% on an annualized basis in July, compared to its peak of 8.8% in March 2023. “With wage growth cooling to around 4%, there is room for inflation to decline further in areas like restaurants,” he adds.

Inflation in housing construction remains high

Housing costs rose slightly in July, from 0.23% in June to 0.38%. Housing costs, which include rent and similar homeowner expenses, have been one of the biggest drivers of inflation over the past two years.

“Year-over-year, housing inflation is running at 5% and is the sole reason why core inflation is above the Fed's 2% target,” says Caldwell. Without inflation, the Fed's preferred inflation rate would be 2%, he explains.

Real-time housing cost data typically comes out with a lag compared to CPI data, suggesting there is more room for housing cost inflation to decline in the coming months. “Current rent data strongly suggest that housing cost inflation should continue to ease,” says Caldwell.

Will the Fed cut interest rates in September?

Given some signs of a slowdown in the economy, such as rising unemployment, markets are virtually certain that the Fed will cut interest rates at its September meeting.

According to the CME FedWatch tool, bond futures traders see a 56.5 percent chance of a 0.25 percent cut in the fed funds rate and a slightly lower chance of a 0.50 percent cut. Markets see a 43.20 percent chance that the target fed funds rate will fall between 4.25 and 4.50 percent by the end of 2024, a total cut of one percentage point.

Caldwell's base case for September is a 0.25% cut, which would bring the target federal funds rate to a range of 5.00% to 5.25%. “While the rise in the unemployment rate is raising red flags, other labor market indicators are looking more favorable,” he says. “Not to mention that economic activity continues to grow at a solid pace for now, although we expect a slowdown next year.”

In the longer term, says Caldwell, “optimal monetary policy requires a sharp cut in the federal funds rate in a short period of time.” Markets seem to agree, with traders expecting a 2% cut in the federal funds rate by the Fed's September 2025 meeting.