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Yesterday, the Bureau of Labor Statistics reported that all-items inflation rose at just a 3% annual rate in June. That was a huge drop from the 4% annual rate reported in May.

The inflation numbers immediately prompted Wall Street to, again, declare that the Federal Reserve’s cycle of interest rate increases would end “soon.” “Soon” is now defined as after the Fed’s July 26 meeting. Fed officials have been so adamant in recent days about the need for more interest rate increases that the odds of 25 basis point increase at the July 26 meeting barely budged after the June CPI report. Today the CME FedWatch Took, which calculates the odds of a Fed move by looking at prices in the Fed Funds Futures market (and is, thus, a measure of investor sentiment rather than speculation on Fed thinking) puts the odds of a July 26 25 basis point increase at 92.4%. That’s down only slightly from the 94.2% odds before the CPI inflation report.

The big move has been in the odds for a second 25 basis point increase at the Fed’s September 20 meeting. Today, the odds are just 11.1%. That’s down from 13.2% odds of a 25 basis point move in September on July 12. And down big from 27.5% odds of another interest rate increase in September on July 6.

And there’s the Fed’s problem.

The market is convinced, at the moment, that the Fed won’t raise rates at the September meeting. July 26 will, therefore, the market believes, mark the peak in interest rates from the central bank for this cycle.

At this moment, a second 25 basis point increase at the September 20 meeting would come as a big surprise to the financial markets.

And the Fed hates to surprise the markets because it increases the odds of an unexpected something going wrong and creating dangerous volatility.

So if the Fed is serious about the need for a second 25 basis point, the markets are going to need a lot of jawboning at the July 26 meeting and after to move those odds back toward a 25 basis point increase in September.

I think the inflation hawks at the Fed can make a good case for a September 20 interest rate increase. While all-items inflation, the headline number that everybody reports, fell to 3%, the core inflation rate, the one that excludes energy and food prices and that is the inflation rate that the Fed watches, barely budged. Core CPI inflation actually climbed by 0.2% in June from May. That’s the smallest month to month increase in core inflation since August 2021, but it still leaves core CPI inflation running at an annual rate of 4.8%.

If you’re a Federal Reserve official who really wants to stuff inflation back in the box down near 2%, a 4.8% core rate is way too high. And the drop in the all-items rate to an annual 3% rate depends far too much on a big drop in energy prices. The energy inflation sub-index in the CPI is now down 16.7% for the 12 months ending in June.

Complicating the picture, it’s not clear how unified the Federal Reserve is on the need to push core inflation lower. Minutes from the June meeting, when the Fed skipped a rate increase, show Fed chair Jerome Powell holding together a divided Fed by promising that the June skip wasn’t a sign of a permanent end to rate increases. And that the Fed would revisit a rate increase in July and September. It’s not at all clear whether Powell can manufacture the unanimity that he treasures at a September meeting.

To me it looks like even if the Fed does decide, ultimately, on a 25 basis point increase on September 20, the market is likely to see that move as the last hurrah for interest rate increases.

In other words, even if the July 26 meeting isn’t the peak in the Fed’s short-term interest rates, the September 20 meeting will be.

This stock market is very good at looking past a Fed meeting or two to see the end of interest rate increases. I’d anticipate that tendency to continue. Which does imply that the direction for stocks is upward–as long as the economy is only slowing instead of dipping into a true recession.

But in the short term, I’d listen to what the Fed says after the July 26 meeting. Do you hear the Fed trying to talk the market into the possibility of a September 20 rate increase? If enough investors and traders get convinced that September and not July is the peak for interest rates, we could get downside volatility in August, especially if the next report on growth in the U.S. economy, the July 27 GPD report, raises fears that the economy is slowing more than expected. Note the timing: GDP will be reported a day after the Fed meets. (Of course, the Fed will know the results of the GDP report before its meeting.)