Deriving PCE from CPI, what kind of performance would lead the Federal Reserve to not cut rates or to significantly reduce the rate cut?

For the September U.S. CPI, Bank of America (BofA) predicts that the overall and core CPI will record a month-on-month increase of 0.1% and 0.3%, respectively. On a year-over-year basis, BofA expects the overall CPI to decrease by 0.2 percentage points to 2.3%, while the core CPI will remain at 3.2%. BofA's expectation for the core CPI month-on-month is higher than the market consensus.

Similar to last month, BofA anticipates that core inflation will be subject to upward pressure from airfare prices and the cost of lodging away from home. Apart from these more volatile items, rent will continue to be a major source of inflation stickiness. Another item to closely monitor is used car prices; wholesale auto auction prices have risen in recent months, which should be reflected in September's used car prices.

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Additionally, based on BofA's forecast for September CPI and assumptions about PCE components, the current expectation is for a month-on-month increase in core PCE inflation of 0.18%. While this would be a decent figure, BofA expects that this data will neither be weak enough to trigger a strong market reaction nor strong enough to alter the widespread consensus for a 25 basis point rate cut in November.

The performance of CPI components will be an important factor in assessing the impact on Federal Reserve policy. If the core PCE month-on-month reaches or exceeds 0.3%, it would indicate a more pronounced acceleration trend compared to the previous months. BofA believes that the core PCE month-on-month must reach at least 0.3% for the market to view the likelihood of policy remaining unchanged and the possibility of a rate cut in November as equally likely.

How to determine whether the Federal Reserve will keep interest rates unchanged or cut them by 25 or 50 basis points in November? BofA points out that the market's current pricing for a rate cut in November is 21 basis points, indicating that the market believes there is a 16% chance the Federal Reserve will keep rates unchanged. The last time the Federal Reserve stopped cutting rates after a 50 basis point reduction (excluding bringing rates to zero) was in November 2002. The circumstances at that time were completely different from the present. Even after last week's strong non-farm payrolls report, Federal Reserve officials still indicated a propensity for further rate cuts, so BofA believes it is unlikely that the Federal Reserve would change its policy direction due to one month's inflation data.

In analyzing the potential range of rate cuts for the remainder of 2024, BofA notes that the impact on PCE components based on different possibilities of CPI data performance is crucial. If the core CPI reaches 0.3% as BofA expects, but the increase is concentrated in components that have a smaller impact on PCE (such as rent), then the market's repricing of rate cuts will be minimal. As previously mentioned, BofA believes that at least a 0.3% core PCE month-on-month is needed for the November rate cut pricing to become a 50-50 split between holding steady and a 25 basis point rate cut. If the core PCE reading is very weak (possibly at 0.1% or below), the market may reconsider the possibility of a 50 basis point rate cut.

Additionally, tonight's CPI data will be a test to measure whether buyers are returning to the U.S. Treasury market after recent selling. The last time the 10-year Treasury yield exceeded 4% was in early August when the U.S. released an unexpectedly weak jobs report. If the CPI report confirms that the trend of slowing inflation continues, BofA expects a slight return of U.S. Treasury buying in the market, especially in the short and medium-term parts of the yield curve, as investors remain cautious about election risks and skeptical about the possibility of an economic "hard landing."

If the CPI data overturns the narrative of slowing inflation, it could lead to more U.S. Treasury long positions being closed out in the market. Current Commodity Trading Advisors (CTAs) still have room to reduce their historically long positions in 10-year Treasury contracts. A strong CPI reading could not only further exclude rate cut expectations from short-term yields but also prompt the market to reassess the upper limit of the neutral interest rate, leading to a more parallel yield curve sell-off.