Recent economic data on wholesale and consumer prices are pointing toward continued easing of U.S. inflation, setting the stage for a modest increase in the Federal Reserve’s preferred inflation gauge—the Personal Consumption Expenditures (PCE) index. The PCE index is highly regarded as the most precise measure of inflation, making it a critical tool for the Fed in determining whether to adjust interest rates.
The Federal Reserve’s decision-making process on interest rates is closely tied to the PCE index. This index is considered the most accurate reflection of consumer price changes, as it captures a broader range of expenditures and adjusts for changes in consumer behavior, unlike other measures such as the Consumer Price Index (CPI). As such, the PCE index is central to the Fed’s monetary policy strategy, particularly in its pursuit of stable prices and maximum employment.
According to Wall Street economists, the PCE index is projected to show a 0.2% increase in both its headline and core rates when the July report is released in two weeks. The headline rate includes all items, while the core rate excludes volatile food and energy prices, providing a clearer view of underlying inflation trends. In June, the annual rate of PCE inflation stood at 2.5%, inching closer to the Fed’s long-term target of 2% annual inflation. The core PCE rate, which is closely watched by the Fed, rose by 2.6% over the 12 months ending in June.
These figures suggest that inflation is gradually cooling but remains slightly above the Fed’s target. However, the Fed is unlikely to wait until inflation fully returns to the 2% target before considering interest rate cuts. Historically, the Fed has often acted preemptively, and current trends suggest that rate cuts could be on the horizon as inflationary pressures continue to moderate.
One of the key reasons for the expectation that the Fed may not wait for inflation to drop to exactly 2% is the nature of the 12-month inflation rate calculation. The current annual PCE rate includes data from the months of October to December 2023, a period when the PCE inflation index posted several weak readings. These lower readings helped bring down the overall annual rate, but as these months begin to fall out of the 12-month calculation, the rate may stabilize around the 2.5% mark unless there are significant monthly declines in inflation.
However, for the yearly PCE rate to decline further, monthly inflation would need to decrease consistently over the next five months. While such a decline is possible, it is relatively rare for monthly inflation indexes to show outright decreases, particularly in a stable economic environment. Typically, inflation indexes show either modest increases or fluctuations around a stable level.
Given this context, the Federal Reserve may find itself in a position where the PCE inflation rate hovers slightly above its target, but other economic indicators, such as slowing economic growth or labor market dynamics, could prompt a move toward cutting interest rates. The Fed’s broader mandate includes not just controlling inflation but also supporting employment, and any signs of economic slowdown could tip the scales toward easing monetary policy.
In summary, while the PCE inflation gauge is expected to show only a modest increase in July, this data, combined with other economic indicators, could be sufficient to prompt the Federal Reserve to consider cutting interest rates. The Fed’s strategy will likely balance the goal of achieving its inflation target with the need to support the broader economy, and the coming months will be crucial in shaping its next moves. As inflationary pressures ease, the path to lower interest rates may become clearer, potentially leading to more accommodative monetary policy before the end of the year.
