Why subdued inflation will allow Fed to cut rates later this year

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With no surprises in the release of the producer price index, the Federal Reserve will have flexibility on rates, as inflation remains in check.

On a year-over-year basis, the core price index, which excludes food and energy, rose 2.3% in May, down from a 2.4% rise in April. It was the lowest reading since January 2018. in line with expectations from economists polled by IFR Markets.

The year-over-year headline PPI number was up 1.8%, after rising 2.2% the month before. Economists expected a 1.9% gain.

For the month, PPI rose 0.1% and the core grew 0.2%, as expected.

The report “validates the Fed's and the market's comfort that inflation is pretty well behaved,” said Mark Heppenstall, chief investment officer at Penn Mutual Asset Management. “It doesn't pose a risk even if the economy were to perform better than most market participants are expecting at this point in the cycle.”

And even though this “is probably not enough to sustain bond prices significantly higher from this point forward,” it gives the Fed “a little more flexibility” for a rate cut, which, Heppenstall says, could happen as soon as September, “depending on a lot of variables.”

While “an uptick in the data excluding food, energy and trade services is worth noting,” said Andrew Dassori, CIO of Wavelength Capital Management, “the overall measure is consistent with the pressure we're seeing on prices. This offers the Fed some additional flexibility with interest rates which we expect will continue to drive market action.”

PPI excluding food, energy and trade services gained 0.4% in the month, more than expected, and grew 2.3% on an annual basis, up from a 2.2% rise in April.

If economic growth slows, Scott Anderson, chief economist at Bank of the West Economics, said, “Slowing inflation may give the Fed a window to lower the fed funds target rate later this year.”

Karissa McDonough, fixed income specialist at People's United Advisors, said, “As we’ve seen recently, the Fed is moving (in measured steps) towards market expectations of three cuts by the end of 2020.”

Several Fed officials have noted they will do what it takes to keep the expansion going. As such, McDonough said, “We believe that we will see at least two of those cuts materialize, sooner rather than later.”

Also released Tuesday, the National Federation of Independent Business' small business optimism index rose to 105.0 in May, its highest level since October, from 103.5 in April.

“Capital spending plans increased sharply accompanied by a significant increase in actual outlays in the preceding months,” the report said.

“Small business owners are demonstrating a continued confidence in the strength of the economy and are betting capital spending dollars on it,” said NFIB Chief Economist William Dunkelberg. “This solid investment performance is supporting ongoing improvements in productivity and real wages.”

It was the fourth consecutive month that optimism rose and the index “is firmly above the six-month average of 102.9,” Bank of the West’s Anderson said. “Inflation pressures remain subdued with the net percent of owners raising average selling prices falling three points to 10%. However, plans to increase compensation remain at historically high levels as 25% of small business owners cite the difficulty of finding qualified workers as their single most important problem.”

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