This week's two crucial inflation reports will determine the magnitude of the Fed's interest rate reduction.

• This week, the Fed will have its final glance before its policy meeting next week, which will rely on inflation readings to determine the magnitude of the anticipated interest rate reductions.
• The jobs report on Friday did not provide much clarity on the issue, so the consumer and producer price index readings will be used to help resolve it.
• The focus of Fed officials has shifted from controlling inflation to addressing concerns about the labor market.

This week, the Federal Reserve will examine inflation data for the final time before deciding on the size of an anticipated interest rate reduction.

The Labor Department's Bureau of Labor Statistics will release its consumer price index (CPI) report for August on Wednesday, and a day later, the BLS will issue its producer price index (PPI) for August, which serves as a proxy for costs at the wholesale level.

The only question remaining about the Fed's decision to cut rates during its next policy meeting on September 18 is the extent of the reduction. Although Friday's jobs report did not provide much clarity on the issue, the CPI and PPI readings may help to clarify the situation.

"Veronica Clark, a Citigroup economist, stated in a note that while inflation data has been less influential on Fed policy compared to labor market data, the upcoming decision on the first rate cut on September 18 could be impacted by August CPI data, as markets and likely Fed officials are divided on the appropriate size of the rate cut."

The consensus forecast of the Dow Jones predicts a 0.2% increase in the CPI for both the all-items and core measures. This translates to annual inflation rates of 2.6% and 3.2%, respectively. Additionally, the PPI is expected to increase by 0.2% on both the headline and core measures. Fed officials tend to focus more on the core measure as a better indicator of long-term trends.

While the CPI readings are not closely aligned with the Fed's 2% long-run target, it is important to consider a few caveats.

While the Fed focuses on the CPI, it is not its primary indicator of inflation. Instead, the Commerce Department's personal consumption expenditures price index, which recently reported headline inflation at 2.5% in July, serves as the principal yardstick for inflation.

Policymakers are as concerned about the direction of movement as much as the absolute value, and the trend for the past several months has been a decided moderation in inflation. Specifically, the August 12-month CPI forecast would represent a 0.3 percentage point decline from July on headline prices.

The focus of Fed officials has shifted from controlling inflation to concerns about the labor market. Since April, hiring has slowed significantly, with the average monthly gain in nonfarm payrolls decreasing from 255,000 to 135,000, and the number of job openings has decreased.

A baby step to start

With the increased emphasis on work, there is growing anticipation that the Fed will begin reducing rates. The current benchmark fed funds rate is between 5.25% and 5.50%.

"According to Dean Baker, co-founder of the Center for Economic and Policy Research, the August CPI report should demonstrate more advancement in reducing the inflation rate to the Fed's 2.0 percent objective. In the event of no unexpected developments, the report should not discourage the Fed from making a rate reduction, possibly a significant one."

The Fed's slow start appears to have been accepted by markets.

The CME Group's FedWatch showed that the odds of the Federal Open Market Committee starting an easing campaign with a quarter percentage point reduction on Tuesday were 71%, while the chance of a more aggressive half-point cut was only 29%.

Some economists, though, think that could be a mistake.

Samuel Tombs, Pantheon Macroeconomics' chief U.S. economist, predicts that the "summer slowdown will likely be even more pronounced in the coming months," and the trend in hiring will continue to decline.

"FOMC members who spoke after the jobs report but before the pre-meeting blackout are still leaning towards a 25 basis point easing this month, according to Tombs. However, by the November meeting, with two more employment reports in hand, the case for rapid rate cuts will be overwhelming."

While market pricing shows a slight decrease in cuts starting in September, it is projected to reduce by half a point in November and potentially another in December.