A Mild Increase in the Fed's Preferred Inflation Gauge Sets the Stage for a Rate Cut

The Federal Reserve’s preferred gauge of underlying inflation in the U.S. rose modestly in July, while household spending saw a slight uptick, reinforcing expectations that policymakers may begin cutting interest rates as soon as next month.

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The core personal consumption expenditures (PCE) price index, which excludes volatile food and energy prices, increased by 0.2% from June, according to data released Friday by the Bureau of Economic Analysis. On a three-month annualized basis—a measure that economists believe offers a more accurate reflection of inflation trends—the index rose by 1.7%, marking the slowest pace this year.

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Despite the increase in spending, the growth in household income was significantly slower, and the saving rate fell. This raises concerns about the sustainability of consumer spending in the future.

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The data released on Friday bolsters the argument that it might be time to start easing the restrictive monetary policies currently in place. Alongside emerging signs of weakness in the labor market, the continued cooling of inflation helps explain why Federal Reserve Chair Jerome Powell recently stated that “the time has come” for the central bank to begin lowering borrowing costs, potentially starting next month.

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“This confirms that inflation is on a cooling path and has moved away from the reacceleration we observed earlier in the year. That’s encouraging,” noted Diane Swonk, Chief Economist at KPMG. “However, the real focus will be on what happens in the labor market.”

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In response to the data, the S&P 500 opened higher, and two-year Treasury yields also rose. Meanwhile, swaps traders maintained their expectations for the total rate cuts they anticipate from the Fed throughout 2024.

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In separate data released on Friday by the University of Michigan, one-year inflation expectations fell to their lowest level since the end of 2020. However, consumers still reported feeling financially stretched, which could pose risks to future spending.

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Policymakers are closely monitoring inflation in the services sector, excluding housing and energy, as it tends to be more persistent. This particular measure increased by 0.2% in July for the second consecutive month, according to the BEA. Compared to a year ago, it rose by 3.25%, the slowest rate in over three years.

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Federal Reserve officials have indicated that they are placing greater emphasis on the employment side of their dual mandate, partly because the labor market’s trajectory will significantly influence expectations for consumer spending, which remains the primary driver of the U.S. economy. The much-anticipated August jobs report, due next week, will be the last major piece of economic data that policymakers will review before their September 17-18 meeting.

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Inflation-adjusted consumer spending increased by 0.4% in July, accelerating from the previous month. This growth was largely driven by spending on goods, particularly motor vehicles, which rebounded following a disruption in sales caused by a cyberattack. In contrast, spending on services grew at a more modest pace.

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However, the report also delivered disappointing news on income growth. Inflation-adjusted disposable income barely increased for the second consecutive month, and the saving rate fell to 2.9%, the second-lowest level since 2008.

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Wages and salaries, before adjusting for inflation, rose by 0.3%, a slight improvement from June but still lower than most of the gains seen earlier in 2023.

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The overall picture painted by the report suggests a mixed outlook for the U.S. economy. On one hand, the moderation in inflation and slight increase in consumer spending could support the case for the Federal Reserve to begin easing monetary policy. On the other hand, the weak income growth and declining saving rate raise concerns about the resilience of consumer spending, which could hinder economic growth moving forward.

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As the Federal Reserve prepares for its upcoming meeting, the data released in the coming weeks, particularly the August jobs report, will be critical in shaping the central bank’s decisions on interest rates. While there is growing support for rate cuts, the Fed will likely weigh these decisions carefully against the backdrop of an uncertain economic environment.

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