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The Federal Reserve signaled on September 20 that interest rates may need to rise further to combat inflation.
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The Federal Reserve’s fight against inflation is back on track after a summer surge, with the central bank’s preferred measure of price growth falling to its lowest level since September 2021, an encouraging sign.
For investors, that means the Fed may be less likely to raise interest rates – already at a generational peak – again in November or December, giving a boost to the stock market, which has been hit lately by worries about the future interest rates were shaken.
The core personal consumption expenditure price index, also known as the core PCE deflator, rose 3.9% from a year earlier in August, compared with a revised reading of 4.3% in July, in line with expectations of economists surveyed by FactSet.
The core PCE deflator rose 0.1% month-on-month, compared with 0.2% in July and below expectations of 0.2%.
This is the first time in nearly two years that core PCE has been below 4%, a milestone for markets that have seen the Fed’s most aggressive rate hike cycle since the 1980s, a key headwind for stocks and a driver of recent rate hikes Annual sale.
“The Fed’s aggressive campaign is working,” said Carol Schleif, chief investment officer at BMO Family Office. “The challenge is that core PCE remains nearly double the Fed’s 2 percent target, prompting the Fed to keep the possibility of another rate hike in play.”
In fact, there is still a lot of work to be done – but investors know that. The Fed signaled after its latest monetary policy decision last week that borrowing costs may need to rise further to sufficiently contain inflation. That message added pressure on stocks and pushed the benchmark 10-year Treasury yield to its highest level since 2007.
Still, recent insights into inflation have led traders to reiterate their bets that the Fed will take a more dovish approach. The CME FedWatch tool, which tracks interest rate futures, showed the probability of a rate hike at the Fed’s November policy meeting is 15%, compared with 19% on Thursday and 28% a week ago. Some market participants are even more optimistic about the prospect of interest rate cuts next year.
“Barring a dramatic re-acceleration of this monthly pace, which is unlikely given the cooling labor market and sharp decline in housing inflation, we continue to expect core PCE inflation to fall well below the Fed’s forecast of 3.7% for the end of this year will fall,” said Andrew Hunter, an economist at Capital Economics. “That should help ensure that the Fed’s next step will be to start cutting rates again early next year.”
But challenges remain. The headline PCE, which takes into account volatile food and energy prices that are left out of the core measure, paints a less positive picture as higher oil prices drive up the cost of living. Total PCE rose 3.5% from a year ago, in line with expectations but reaching its highest level since May.
Energy prices rose 6.1% compared to July, making them by far the largest contributor to the PCE increase. Oil prices have rebounded from summer lows, pushing the price of West Texas Intermediate crude, the benchmark for the U.S. oil market, to its highest level in more than a year this week, a sign that those pressures are continuing becomes.
“If oil prices continue at higher levels, they will soon penetrate the depths of the broader economy and push up a number of prices,” said Quincy Crosby, chief global strategist at LPL Financial. “The Fed must be pleased with the overall direction of the PCE report, but it would be premature to declare a victory in containing inflation.”
Investors may not be declaring victory, but celebrations dominated Friday’s trading. The yield on the 2-year Treasury note, an indication of the market’s interest rate outlook over the next few years, fell slightly to 5.02% from 5.08% previously. The Dow Jones Industrial Average was last up 110 points, or 0.3%, while the S&P 500 gained 0.7%.
September is historically the worst month for stocks, and this was no exception. But the latest inflation release at least helps investors end the month on a positive note.
Write to Jack Denton at [email protected]