Market Minute: Gradual Rate Cuts Match a Resilient Economy

Equities closed higher yesterday after a meaningful reversal erased the early declines which started the trading day. The final CPI reading before next week’s Fed’s meeting illustrated mixed results, with headline and core CPI growth mostly in line with expectations. Headline inflation fell to 2.5% in August, compared with July’s 2.9% pace, and was slightly below the estimate of 2.6%. Durable goods prices dropped along with energy while food prices remained roughly stable.  

One exception is core services inflation which remains elevated and reaccelerated for the second month in a row in August, to 4.9% on an annualized basis. Core services make up about 65% of the CPI and include housing, healthcare, and insurance. With core CPI rising at its fastest pace in four months and economic activity indicators still painting a mixed picture of the economy, policymakers may find it tough to justify a sizeable half-point reduction in the policy rate.

In a nutshell, inflation continues to trend marginally lower, setting the stage for the Fed to begin cutting its policy rate next week by 25 basis points. We can ascribe yesterday’s bullish reversal to the notion that a gradual reduction in interest rates removes the sense of urgency associated with an economy that is weakening faster than previously anticipated. The economy is slowing, yet still growing, and cutting rates too quickly runs the risk of another bout of inflation. Since markets follow the path of the economy, resilience in the economy minimizes the need for rapid rate cuts, which can be interpreted as bullish for equities.