Wall Street sees September rate cut as sure thing - CPI inflation data may have a lot to say about what comes next

By William Watts

Core CPI reading will matter most as investors look for signs of upward pressure on services inflation: strategists

Inflation fears haven't been put to bed.

Investors probably won't sweat this week's inflation data as they fully pencil in a Federal Reserve rate cut following clear signs the labor market is slowing down. They shouldn't take it too far.

Fed-funds futures traders on Friday priced in a 100% probability of a rate cut on Sept. 17 after nonfarm payrolls showed a rise of just 22,000 in August, accompanied by downside revisions to previous months that pushed the June reading into negative territory. Even the possibility of an outsize 50 basis point cut was put on the table, with traders pricing in a 11% probability of an outsize move, according to the CME FedWatch Tool.

"I think it would be very difficult to have a CPI number that offsets the jobs report...That said, I think it's worth talking about inflation as a macro risk for markets," Lauren Goodwin, economist and chief market strategist at New York Life Investments, told MarketWatch in a phone interview.

And for his part, Chicago Federal Reserve Bank President Austan Goolsbee, a voting member this year of the rate-setting Federal Open Market Committee, said Friday he was still on the fence about whether to back a September cut. "We've got to look at the inflation side, too," he told Bloomberg Television.

Goolsbee and everyone else will get that look beginning on Wednesday, with the release at 8:30 a.m. ET of the August producer-price index. The main event will be Thursday, with the release of the August consumer-price index.

Economists expect CPI to show a 0.3% monthly rise and to increase 2.9% year over year, up from 2.7% in July. Core CPI, which strips out volatile food and energy components, is expected to show a rise of 0.3% with the year-over-year rate steady at 3.1%.

The details of the core CPI reading will matter most, said Ian Lyngen and Vail Hartman, rates strategists at BMO Capital Markets, in a Friday note.

"The risk we're worrying about is a repeat of July's composition - soft goods inflation with sticky services pressure - that isn't as easy to ignore," they wrote. "A one-off, airfare-inspired price adjustment as was seen in July is easy to dismiss. However, if there is a broadening out of service sector reflation, one would be remiss not to assume it would have a limited impact on the extent to which the Committee will be willing to signal future rate cuts."

Investors will also get another look at the jobs market this week, with the release Tuesday of a set of revisions known as the Quarterly Census on Employment and Wages. Wall Street economists expect it to show the U.S. added 500,000 fewer jobs between April 2024 and March 2025 than previously reported - but the tally could be as high as 1 million fewer jobs.

Investors are confident that Goolsbee will be in the minority if he holds out against a September rate cut. But the inflation data may shape expectations for further cuts given expectations tariff-related price pressures have yet to fully feed through at the retail level.

Stocks opened higher following the Friday jobs data as investors priced in a total of 75 basis points of cuts by year-end, but later pulled back to end the session slightly lower. Still, it was a winning week for the S&P 500 SPX, which rose 0.3% and closed at a record on Thursday, and the tech-heavy Nasdaq Composite COMP, up 1.1%. The Dow Jones Industrial Average DJIA lagged behind, losing 0.3% for the week. Treasury yields dropped and the U.S. dollar sank following Friday's data.

Read: The S&P 500 must stay above 6,400 for the rally to continue - after August jobs report rattles market, strategist says

Stock-market bulls are counting on a "bad news is good news" dynamic, in which soft labor data and signs of a weakening economy pave the way for rate cuts while averting a recession.

Meanwhile, uncertainty about exactly how tariff measures will translate into price pressures is what has kept the Fed on the sidelines in 2025, much to the anger of President Trump.

But last month, in his speech in Jackson Hole, Wyoming, Fed Chair Jerome Powell put the emphasis on concerns about a weakening jobs market, indicating policymakers were on the path to delivering a cut at the September meeting.

Estimates of how much of the tariff-related increases in prices of imported goods are being passed through to the retail level will be a key thing to watch in the months ahead, said Freya Beamish, chief economist at GlobalData TS Lombard, in a Friday note.

"A 50% passthrough rate, up from 10-20% currently would imply PCE inflation above 3%," Beamish wrote, referring to the personal-consumption expenditures index, the Fed's favored inflation gauge. The Fed's inflation target is 2%.

Beamish expects the jobs market to see a rebound in the fall, with recent "blurred signals" likely a response to a tariff-induced slowdown that's dragging on the economy but unlikely to push it into recession.

And it won't take much of a labor market recovery to prompt what Beamish says is a still independent Fed to start sounding hawkish again. "For now, the Fed leans towards a level shift in prices, resulting from tariffs. But the bigger picture is an upshift in the rate of inflation," she said.

New York Life's Goodwin doesn't expect tariffs to a drive a sharp spike in PCE, but noted that a persistent run of 0.3% or so monthly increases could present a challenge for consumers and businesses, while the risk of a bigger surge is one that should be acknowledged by investors.

That said, Goodwin puts low odds on a "double peak" that would see CPI pushing back toward the year-over-year top above 9% it scored in 2022. A double peak would require the market coming to believe the Fed has changed its "mindset" toward inflation.

While Trump is widely viewed as attempting to reshape the Fed to allow for lower interest rates than would otherwise be the case, the market reaction thus far, pricing in three rate cuts in 2025 and a few more in 2026, indicates investors don't see the central bank materially changing its approach.

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"I think the market is expecting too much from the Fed, but based on where we are in the economic cycle that's not an egregious mispricing," she said.

So even if the 200 basis points or so in rate cuts penciled in by the markets is likely too ambitious, the signaling of sporadic rate cuts will likely be enough to limit downside for U.S. stocks over the next six to nine months, Goodwin said, as investors monitor how tariffs and other policy changes work their way through the economy.

-William Watts

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09-07-25 1200ET