Inflation Falls to Lowest Level Since 2021, Boosting Hopes for More Interest Rate Cuts

The cost of living barely edged up in August, making for the lowest annual inflation rate in more than three years. 

Consumer prices as measured by Personal Consumption Expenditures rose 0.1% in August from July, making for a 2.2% increase since August 2023, the Bureau of Economic Analysis said Friday. Forecasters had expected inflation to be slightly hotter at 2.3%, down from 2.5% in July, according to a survey of economists by Dow Jones Newswires and The Wall Street Journal.

It was the lowest annual inflation since February 2021, and marked significant progress in the Federal Reserve’s attempts to bring inflation down to a 2% yearly rate, from a high of 7.1% in 2022. The PCE is the Fed’s preferred measure of inflation.

Cool Inflation Allows Fed to Focus on Labor Market

Cooling inflation could pave the way for the central bank to follow up its reduction of interest rates earlier this month with further rate cuts, to prevent the unemployment rate from jumping. The Fed’s high interest rates since 2022 have put downward pressure on inflation by discouraging borrowing and spending, but have been a drag on the economy to the point where employers have pulled back on job openings.

A lower fed funds rate could help household budgets by lowering interest rates on credit cards and auto loans, and put downward pressure on mortgage rates too.

“To the extent that inflation remains under control – and we continue to trend in that direction—the Fed can focus almost entirely on the labor market, which means a rate cutting bias,” Chris Zaccarelli, chief investment officer for Independent Advisor Alliance, said in a commentary. “As the Fed cuts rates—especially in the absence of recessionary growth—it is a great tailwind for both stock and bond markets and should eventually provide some relief for those consumers that are more interest-rate sensitive.”

It’s Not All Good News on the Inflation Front

Although the report showed inflation generally cooling, some important prices are still rising too fast for comfort. Core inflation, which excludes the volatile prices of food and energy, rose 2.7% over the year in August, up from 2.6% in July and in line with expectations. Core inflation is heavily influenced by rent and other housing costs, which have continued to rise quickly in official government measures, although more up-to-date sources show that rent inflation has slowed dramatically since the pandemic.

Still, if inflation continues to fall in future months, as forecasters expect, the Fed is likely to remain focused on the labor market, since its mandate from congress requires it to both keep a lid on inflation and keep unemployment low. That means how much the Fed cuts rates in the coming months will likely be heavily influenced by reports on job growth an unemployment, especially a report from the Bureau of Labor Statistics next Friday

“Inflation remains on a path back to target, giving the Fed space to continue to cut rates,” David Alcaly, lead macroeconomic strategist at Lazard Asset Management, wrote in a commentary. “The key question looking ahead is whether relief from rate cuts will arrive quickly enough to stabilize a cooling labor market. Next Friday’s jobs report will be closely watched for clues.”