"A weaker-than-expected rise in consumer prices at the start of Q3 further fuels the dovish argument for the Fed to remain on the sideline, delaying liftoff beyond the September FOMC meeting," Lindsey Piegza, chief economist at Stifel Fixed Income, said in a note. "Since the end of 2012, every Fed communication has continued to acknowledge the substandard level of inflation which continues to persist. Thus, at this point, raising rates with inflation so far below the Fed's target could create a misperception in the marketplace that the Fed has lowered their inflation goal."
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Investors will get a closer look at Fed thinking Wednesday at 2 p.m. when the Fed Open Market Committee releases the minutes from its July meeting.
The committee initially had targeted a 6.5 percent unemployment rate and 2.5 percent inflation before tightening policy, but both numbers have become moving targets amid uneven economic growth. Though the headline jobless figure, excluding those not actively looking for work and the underemployed, has fallen to 5.3 percent, the Fed remains handcuffed by the weak inflation readings.
Its preferred gauge for that metric, the personal consumption expenditures price index, shows even a lower level of inflation than the CPI. The core PCE's latest reading, in June, was just 1.3 percent. While consumers might scoff at an inflation gauge that omits food and energy, Fed Chair Janet Yellen generally dismisses price fluctuations in both categories as "transitory" and therefore not central to monetary policy decision-making.
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Low inflation readings, particularly the latest CPI, "will certainly give the Fed pause for thought in whether to raise interest rates or not at the next FOMC meeting in mid-September," Paul Ashworth, chief U.S. economist at Capital Economics, said in a note.
"On balance, we still think the Fed will go ahead and raise rates in response to the cumulative improvement in labor market conditions. But the decision is finely balanced," Ashworth added. "With underlying price inflation and wage growth still muted, a case can also be made for waiting."
Anecdotally, most Wall Street economists seem to expect a September hike. However, traders at the CME are less convinced, with futures trading indicating a 45 percent chance of an increase at the meeting. A month ago, though, the probability was just 26 percent.