Fed’s preferred inflation measure shows signs of cooling

The Federal Reserve’s favored measure of inflation continues to show signs of cooling, accompanied by moderate consumer spending growth—welcome news for central bankers aiming to control rising prices and curb demand.

In May, the personal consumption expenditures (PCE) index increased by 2.6% compared to the previous year, meeting economists’ expectations and slightly down from April’s 2.7% increase. Excluding the more volatile food and fuel prices, the “core” inflation measure also rose 2.6% year-over-year, down from 2.8% in April. On a monthly basis, inflation remained particularly mild, with overall prices showing no significant increase.

The Federal Reserve is likely to scrutinize this new inflation data closely as it considers its next policy moves. Since 2022, the Fed has been aggressively raising interest rates to suppress consumer and business demand, which can help slow price increases. However, since July 2023, borrowing costs have been held steady at 5.3% as inflation has gradually eased. The Fed is now deliberating on the timing of potential interest rate cuts.

Although officials initially expected to implement several rate cuts in 2024, these plans were delayed due to persistent inflation earlier in the year. Policymakers still anticipate one or two rate cuts before the year ends, with investors speculating that the first cut might occur in September. However, this decision will hinge on upcoming economic data, including inflation and labor market metrics.

Despite inflation remaining above the Fed’s 2% annual target, it has significantly slowed from its peak in 2022 when overall PCE inflation hit 7.1%. The consumer price index (CPI), a related measure, peaked even higher at 9.1% and has since decreased substantially.

Fed officials have indicated that rate cuts will commence once they are confident inflation is under control or if the labor market unexpectedly weakens. While policymakers generally expect inflation to decelerate in the coming months, some express concerns about potential stagnation.

“Much of the progress on inflation last year was due to supply-side improvements, including easing supply chain constraints, increased worker availability partly due to immigration, and lower energy prices,” said Michelle Bowman, Fed Governor, in a speech this week. She cautioned that these factors might be less supportive in the future.

Conversely, other officials worry that a broader economic slowdown could soon impact the labor market, fearing that maintaining high interest rates for too long could overly temper growth and harm American workers.

Hiring has remained robust, and while wage growth is cooling, it remains strong. However, some indicators suggest weakening labor conditions: job postings have sharply declined, the unemployment rate has edged up, and jobless claims have risen slightly.

“The job market has been slow to adapt, and the unemployment rate has only risen slightly,” noted Mary C. Daly, President of the Federal Reserve Bank of San Francisco, in a recent speech. “But we are approaching a point where that benign outcome may be less likely.”

The report released on Friday highlighted that consumer spending remained moderate in May, further evidence that the economy is losing momentum.