Fed’s Preferred Inflation Gauge Falls as Price-Growth Fight Gets Back on Track

The core personal-consumption expenditures price index, also known as the core PCE deflator, rose 3.9% year over year in August, down from a revised 4.3% in July and meeting expectations among economists surveyed by FactSet.

The core PCE deflator rose 0.1% month over month, down from 0.2% in July and below expectations of 0.2%.

This is the first time in almost two years that core PCE has stood below 4%, a milestone for markets that have faced the most aggressive cycle of rate-hikes from the Fed since the 1980s, a key headwind for stocks and a driver of last year’s selloff.

“The Fed’s aggressive campaign is working,” said Carol Schleif, chief investment officer at BMO Family Office. “The challenge is that core PCE remains almost double the Fed’s 2% target, prompting the Fed to keep the possibility of another rate hike in play.”

Indeed, there is still more work to do—but investors know that. The Fed signaled after its latest monetary policy decision last week that borrowing costs may need to rise further to sufficiently constrain inflation, a message that heaped new pressure on stocks and sent the benchmark 10-year Treasury yield to its highest level since 2007. 

Nevertheless, the latest glimpse into inflation has seen traders firm up bets that the Fed will be more dovish. The CME FedWatch Tool, which tracks interest-rate futures, showed the odds of a rate increase at the Fed’s November policy meeting at 15%, down from 19% on Thursday and 28% a week ago. Some market participants are even growing more optimistic about the prospect of rate-cuts next year.

“Barring a dramatic re-acceleration in that monthly pace, which is unlikely given the cooling labor market and the sharp downturn in housing inflation, we continue to expect core PCE inflation fall well below the Fed’s 3.7% projection for the end of this year,” said Andrew Hunter, an economist Capital Economics. “That should help ensure that the Fed’s next move will be to start cutting rates again early next year.”

But challenges remain. Headline PCE, which includes the volatile food and energy prices that the core measure strips out, tells a less upbeat story, with higher oil prices pushing the cost of living upward. Headline PCE jumped 3.5% from a year ago, in line with expectations but the highest level since May.

Energy prices increased 6.1% from July, making them by far the largest contributor to the rise in PCE. Oil has rallied from its summer lows, sending the price of West Texas Intermediate crude, the U.S. oil market benchmark, to its highest level in more than a year this week—a sign that these pressures will continue.

“Should oil prices continue to remain at higher levels … they will soon travel their way into the crevices of the broader economy pushing up an assortment of prices” said Quincy Crosby, chief global strategist at LPL Financial. “The Fed must be pleased with the overall direction of the PCE report, but declaring victory on quelling inflation would be premature.”

Investors may not be declaring victory, but celebration was defining Friday trading. The yield on the 2-year Treasury note, an indication of the market’s outlook for rates in the next couple of years, edged down to 5.02% from 5.08% earlier. The

Dow Jones Industrial Average
was last up 110 points, or 0.3%, with the

S&P 500
advancing 0.7%.

September is historically the worst year of the month for stocks, and this was no exception. Yet the latest inflation release is, at least, helping investors finish the month on the right foot.

Write to Jack Denton at jack.denton@barrons.com