In the aftermath of the Fed’s most recent rate cut, markets were fairly confident that rates would continue to decline. Since then, some of that optimism has faded. Part of that can be attributed to Fed Chair Jerome Powell’s comments on Tuesday. However, the main reason could be that markets are cautious ahead of the main risk event of the week.
The PCE price index is the Fed’s preferred measure of inflation, covering a broader range of data points. That’s why it could be pivotal for the market’s expectations for the Fed. On Tuesday, Powell emphasized that inflation is still a significant concern for the Fed. Meaning that unless the PCE price index matches forecasts or is lower, markets may start to lose confidence in the easing outlook, which could drag on gold and support the dollar.
What the Market Expects for August PCE?
The consensus among economists is that headline August PCE will speed up slightly to 2.7% from 2.6% prior. Higher gasoline prices in the period are seen as a contributing factor. However, it’s the core rate, which strips out volatile elements such as food and energy, that attracts the most attention. The core August PCE price index is anticipated to stay unchanged at 2.9%, above the Fed’s 2.0% target.
That puts the data at a crucial point, because if it beats by just one decimal, it will rise to 3.0%. The last time inflation was that high was in January of 2024, back when the Fed was still in hiking mode. Besides moving in the wrong direction, it might prove to be an important psychological level that leaves markets losing hope for a second-rate cut this year.
What Are the Odds of Easing?
In the immediate aftermath of the Fed’s last meeting, where interest rates were lowered by 25 bps, the market was sure that there would be two more rate cuts this year. The odds of an October rate cut have remained above 90% since then. But the odds of that second cut in December have been declining, and are down to 75% in the aftermath of Powell’s comments.
This reduces the distance to where the market starts to price out a December cut. That could be significant for the dollar and gold, if inflation were to come in a couple of decimals above forecasts. The initial reaction might be for the dollar to get stronger, given the prospect of higher interest rates. However, the gains could be short-lived, as higher rates would also imply a slower economy and negatively impact the stock market.
What to Look Out For
The primary concern for the Fed regarding inflation is whether tariffs are contributing to higher consumer prices. The deterioration in the labor market is an indication that CPI would otherwise decline. So, traders will likely be looking for signs of tariff impact in the PCE numbers. If there is an increase in prices in sectors vulnerable to the trade war, such as apparel and auto parts, the market may become more pessimistic about rate cuts.
On the other hand, if inflation is below forecasts, then the market could firm up its odds of a rate cut. That would likely weaken the dollar and support gold, and generally provide relief to the market. Particularly if the effect of tariffs continues to be below forecast.
