Federal Reserve officials received more good news in their fight against rapid inflation on Friday as a key inflation indicator continued to slow. This is the latest evidence that a return to normality after the pandemic and higher interest rates are helping to reduce rapid price increases back to a more normal pace.
The personal consumption expenditure index, which the central bank uses to define its 2 percent inflation target, rose slightly faster last month, boosted by higher gas prices. They rose 3.5 percent year-on-year in August, compared to 3.4 percent in July.
But after factoring out food and fuel costs, both of which are volatile, a “core” measure of inflation that Fed officials are watching closely begins to cool significantly. This metric increased 3.9 percent year over year, down from 4.3 percent in July. Compared to the previous month, it rose by 0.1 percent, a very restrained pace.
This is the latest encouraging sign for policymakers at the Fed, which has been raising interest rates since March 2022 to slow the economy and temper price increases. While economic momentum has held up better than expected, a less buoyant real estate market and a struggling return to normality in the auto market have caused key prices – such as car prices and rents – to weaken. At the same time, the disruptions in the supply chain that led to bottlenecks and sharply rising prices from 2021 onwards have gradually resolved, so that the costs for many goods no longer increased or even fell slightly.
“I don’t think they’re fully convinced yet that core inflation has slowed sustainably; This is another building block in gaining that trust,” said Omair Sharif, founder of research firm Inflation Insights.
Given the progress, central bankers are now considering whether they need to raise interest rates further. They left them unchanged at 5.25 to 5.5 percent at their meeting this month, but forecast they could raise rates again this year. At the same time, with the economy still strong, officials have signaled that they may need to keep interest rates high for longer to ensure inflation returns to normal in a sustained manner.
“We’re taking advantage of the fact that we acted quickly to be a little more cautious now,” Fed Chairman Jerome H. Powell said during a news conference following the Fed’s meeting last week.
Mr. Sharif said he believes the Fed may hold off on raising interest rates in November given the new inflation report, but a hike is still possible in December as inflation could pick up slightly in the fall.
“I don’t think that means another interest rate hike is off the table just yet; I don’t think they’re completely confident yet, and I don’t think they should be,” he said.
Market prices suggested that investors on Friday morning saw a roughly one-third chance of a rate hike in December. Longer-term bond yields have also risen in recent weeks, suggesting that Wall Street is increasingly confident that the Fed will keep its key interest rate higher for longer. Shares rose following Friday’s report.
“This is certainly news that should be classified as ‘very good news’: the stock market loves it, the financial market loves it, and I think that’s the right reaction,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics. “They won’t declare victory based on this report,” but “the emerging downward trend is now pretty clear.”
A key question now is whether inflation can subside completely without a sharper economic slowdown – i.e. return to near the Fed’s 2 percent target and stay there.
So far, the economy has maintained surprising momentum. Retail sales figures and corporate earnings calls suggest that U.S. consumers have managed to continue spending despite higher borrowing costs, which has made it more expensive to make large purchases with borrowed money.
But Friday’s report also contained good news for the Fed when it comes to consumption. Consumers continued to spend money, although not quite as enthusiastically. The report showed that private consumer spending rose 0.4 percent in August from the previous month, a slowdown from July and weaker than economists expected.
In the past, it has been difficult for the Fed to reduce inflation without triggering a major economic downturn. Companies will generally raise prices when they can. Therefore, slower demand is required to force them to stop. Fed policy is a blunt instrument, so it is difficult to calibrate accurately.
And there are still risks. The government is heading toward a possible shutdown, which could hurt economic growth if it continues. Auto industry strikes could affect production of cars and parts if they last longer, and increased crude oil prices could lead to inflation if they spill over and drive up prices at the pump.
But as price increases ease and the economy shows signs of softening, central bankers are signaling they hope they can pull off a rare “soft landing” and cool price increases without slowing growth.
“We will get inflation back to our target, whatever it takes,” Federal Reserve Bank of Chicago President Austan Goolsbee said during a speech this week. “But we must also not lose sight of the fact that the Fed has a chance to achieve something very rare in the history of central banking: defeat inflation without damaging the economy.”