Fed’s Preferred Inflation Measure Shows Signs of Cooling: What’s Next for Interest Rates?
The Federal Reserve’s battle against inflation is making headway as the central bank’s favored inflation gauge, the Personal Consumption Expenditures (PCE) index, showed signs of cooling in May. This development is seen as a positive indicator by economists and central bankers striving to manage demand and bring price increases under control.
The PCE index rose by 2.6 percent in May compared to the previous year, meeting economists’ expectations and slightly down from last month’s 2.7 percent increase. When volatile food and fuel prices are excluded, the core PCE index also showed a rise of 2.6 percent, down from 2.8 percent in April. Notably, inflation remained mild every month, with prices showing no overall increase.
This deceleration in inflation is critical for the Fed, which has been closely monitoring economic indicators to determine its next policy steps. Since 2022, the Fed has significantly raised interest rates to curb consumer and business demand, aiming to slow down price increases. Despite holding borrowing costs steady at 5.3 percent since July, the central bank is cautiously optimistic about lowering rates shortly.
Federal Reserve officials initially expected to make several rate cuts in 2024. However, stubborn inflation earlier in the year has tempered those expectations. Policymakers now suggest that one or two rate cuts could still be possible before the end of the year, with the first reduction potentially occurring in September.
Omair Sharif, founder of Inflation Insights, remarked that the persistent inflation seen early in 2024 now appears merely a “bump in the road.” He emphasized that considerable progress has been made in controlling core inflation over the past year.
Despite this progress, the timing of any rate cuts will heavily depend on future economic data, particularly related to inflation and the labor market. Although inflation is still above the Fed’s target of 2 percent, it is significantly lower than its peak of 7.1 percent in 2022. The Consumer Price Index (CPI), another key measure, also reached a high of 9.1 percent last year but has since moderated.
The Fed has clarified that rate cuts will only be considered when there is sufficient evidence that inflation is under control or an unexpected cooling in the labor market. Fed officials generally expect inflation to continue cooling in the coming months, though some are wary that this process could face interruptions.
Michelle Bowman, a Fed governor, noted that much of the inflation reduction over the past year resulted from supply-side improvements, including easing supply chain constraints, increasing labor force, and lowering energy prices. However, she cautioned that these factors might provide less assistance moving forward.
Conversely, some Fed officials are concerned that a slowing economy might negatively impact the labor market. While hiring has remained strong and wage growth robust, indicators such as a decrease in job openings, a slight rise in the unemployment rate, and an uptick in jobless claims suggest potential weakening.
Mary C. Daly, President of the Federal Reserve Bank of San Francisco, expressed caution, stating, “We are getting nearer to a point where that benign outcome could be less likely.” This sentiment underscores the delicate balance the Fed must strike in its policy decisions.
May’s report showed that consumer spending remained subdued, further indicating that the economy is losing steam. Despite these signs, Diane Swonk, Chief Economist at KPMG, suggested that economic conditions still appear relatively strong. She emphasized that the Fed aims to cool the economy without causing a severe downturn.
“Are we on thin ice yet? Not yet, and it does look like there is room to run,” Swonk said. However, she also highlighted the importance of the Fed’s vigilance in managing economic conditions. “They want to cause a cooling of the economy, not a deep freeze.”
As the Fed’s preferred inflation measure continues to show signs of moderation, the central bank faces critical decisions in the coming months. The balance between maintaining economic growth and controlling inflation remains a delicate one. While the Fed is cautiously optimistic about potential rate cuts, the ultimate decision will depend on various economic indicators. The coming months will be crucial in determining the trajectory of the U.S. economy and the Federal Reserve’s monetary policy.
