• Santander's Stephen Stanley expects the Fed to raise rates in September and again in December, despite July core CPI coming in close to expectations.
  • July core CPI rose 0.215% month-over-month, equivalent to a 2.6% annualized pace, indicating ongoing inflation pressure.
  • The inflation report is unlikely to deter the Fed from its tightening path, with market odds for a September move fluctuating.

July CPI: A Close Call

The July consumer price index report, released earlier today, showed core inflation rising 0.215% month-over-month, a touch below the consensus estimate but still pointing to persistent price pressures. On an annualized basis, that translates to a 2.6% pace, keeping inflation risks firmly on the table. For Santander's chief economist, Stephen Stanley, the data is broadly in line with expectations and does little to change the outlook for monetary policy.

"This report doesn't move the needle much," Stanley said in a note to clients. "The unrounded figures show inflation is still running above the Fed's target, and with the labor market remaining tight, the case for another hike in September remains intact."

A Hawkish Stance

Stanley continues to expect the Federal Reserve to raise its benchmark rate by 25 basis points at the September meeting, followed by another increase in December. This view contrasts with market pricing, which has seen odds for a September move fluctuate in recent weeks as investors weigh mixed economic signals. According to CME Group's FedWatch tool, the implied probability of a September hike currently stands at around 40%, up from 30% a month ago but well below the 70% level seen in early July.

"The market is underestimating the Fed's resolve," Stanley argued. "Core inflation is still running at more than double the target, and with wage growth showing no signs of cooling, the risk of a reacceleration in prices remains high. The Fed will want to see more convincing evidence that inflation is on a sustainable downward path before pausing."

Broader Implications

Stanley's projection implies that the Fed's terminal rate could reach 5.75% to 6.00% by the end of the year, a level that would mark the highest since 2001. Such a path would have significant implications for borrowing costs, asset valuations, and the broader economy. For consumers, mortgage rates, which have already climbed above 7%, could rise further, while businesses may face higher financing costs, potentially dampening investment.

However, some analysts caution against reading too much into a single monthly inflation print. "The July CPI report is one data point in a broader picture," said Jane Smith, an economist at a rival firm, speaking on condition of anonymity. "The Fed will also consider services inflation, labor market conditions, and the trend in PCE inflation, which is their preferred measure. A pause in September is still possible if the data softens in coming weeks."

Market Reaction

Following the release, Treasury yields initially dipped but then stabilized as investors digested the mixed signals. The 10-year yield was trading at 4.05%, down 3 basis points on the day, while the 2-year yield, more sensitive to policy expectations, remained elevated at 4.85%. Equity futures pointed to a slightly higher open, with S&P 500 futures up 0.2%.

"The inflation data came in about as expected, so the immediate reaction is muted," said a portfolio manager at a New York-based asset manager. "The focus now shifts to the Fed's Jackson Hole symposium later this month, where Chair Powell may provide further clues about the September decision."

Looking Ahead

As the debate over the Fed's next move continues, investors will closely monitor upcoming economic reports, including the July jobs report and the July PCE price index, due out later this month. In the meantime, Stanley's call adds to a growing chorus of voices arguing that the Fed's fight against inflation is far from over.

Correction (August 10, 2023): An earlier version of this article incorrectly stated that the annualized core CPI pace was 2.6% based on the monthly increase. The correct annualized rate, extrapolated from the monthly figure, is 2.6%, but the Federal Reserve targets the year-over-year rate, which was 4.7%. We regret the error.