Key inflation index continues slowing

Higher gas prices impact personal expenditures index

Federal Reserve officials received more good news in their battle against rapid inflation Friday, when a key inflation measure continued to slow, the latest evidence that a return to normal after the pandemic and higher interest rates are combining to wrestle rapid price increases back to a more normal pace.

The personal consumption expenditures index, which the central bank uses to define its 2% inflation goal, rose slightly more quickly last month as higher gas prices gave it a boost. It rose 3.5% in August from a year earlier, up from 3.4% in July.

But after stripping out food and fuel costs, both of which are volatile, a “core” inflation measure that Fed officials watch closely is beginning to cool notably. That measure picked up 3.9% from a year earlier, which was down from 4.3% in July. Compared with the previous month, it climbed 0.1%, a very muted pace.

It's the latest encouraging sign for Fed policymakers, who have been raising interest rates since March 2022 in a campaign to slow the economy and cool price increases. While economic momentum has held up better than expected, a less ebullient housing market and a grinding return to normalcy in the car market have helped key prices — such as for automobiles and rents — to fade. At the same time, supply chain disruptions that led to shortages and starkly pushed up prices starting in 2021 have gradually cleared up, allowing costs for many goods to stop rising or even come down slightly.

“I don't think they're fully confident yet that core inflation has sustainably slowed. This is adding another building block on gaining that confidence,” said Omair Sharif, founder of the research firm Inflation Insights.

Given the progress, central bankers are now contemplating whether they need to raise interest rates further. They left them unchanged, in a range of 5.25% to 5.5%, at their meeting this month, while forecasting that they might

make one more rate increase this year. At the same time, given how strong the economy remains, officials have signaled that they may need to leave interest rates set to a high level for longer to ensure that inflation returns to normal in a sustainable way.

“We're taking advantage of the fact that we have moved quickly to move a little more carefully now,” Fed Chair Jerome Powell said during a news conference after the Fed's meeting last week.

Sharif said he thinks the Fed could hold off on a rate move in November in light of the fresh inflation report, but that an increase was still possible in December, because inflation may pick back up slightly this autumn.

“I don't think this takes another rate hike off the table just yet. I don't think they're fully confident yet, and I don't think they should be,” he said.

Market pricing suggested that investors saw roughly a one-third chance of a rate increase in December as of Friday morning. Longer-term bond yields have also moved up over recent weeks, suggesting that Wall Street is increasingly convinced that the Fed will keep its policy rate higher for longer. Stocks climbed after Friday's report.

“This is certainly one to file under `very welcome news': The stock market loves it, the Treasury market loves it, and I think that's the right reaction,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics. “They're not going to declare victory on the back of this report” but “the emerging downward trend is pretty clear now.”

A key question now is whether inflation can fade fully — getting back to something near the Fed's 2% goal and staying there — without a bigger economic slowdown.

So far, the economy has retained surprising momentum. Retail sales figures and company earnings calls have suggested that American consumers are managing to keep spending despite higher borrowing costs, which have made it more expensive to make big purchases on borrowed money.

But Friday's report also contained good news for the Fed when it comes to consumption. Consumers continued to spend, but not quite as enthusiastically. The report showed that personal consumption expenditures climbed 0.4% in August from a month before, a slowdown from July and softer than what economists had expected.

Historically, it has been difficult for the Fed to wrestle inflation lower without causing a big economic pullback. Companies will generally raise prices if they can, so it requires slower demand to force them to stop. Fed policy is a blunt tool, so it is hard to calibrate it exactly.

And risks still loom. The government is barreling toward a potential shutdown, which could hurt economic growth if it lasts. Auto industry strikes could disrupt the production of cars and parts if they are protracted, and elevated crude oil prices could feed into inflation if they spill over to push up prices at the pump.

Yet as price increases fade and the economy shows signs of settling down gently, central bankers have been signaling that they are hopeful they will be able to pull off a rare “soft landing” and cool price increases without killing growth.

“We will get inflation back to our target, whatever that takes,” Austan Goolsbee, the president of the Federal Reserve Bank of Chicago, said during a speech this week. “But we also can't lose sight of the fact that the Fed has the chance to achieve something quite rare in the history of central banks: to defeat inflation without tanking the economy.”