What Friday's Inflation Report Tells Us About Future Interest Rate Cuts

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Key Takeaways

• A closely watched government report showed that prices were essentially unchanged in May, a welcome sign for those hoping for relief from inflation and the high interest rates designed to combat it.
• The annual inflation rate as measured by the Personal Consumption Expenditures (PCE) index, the Federal Reserve's preferred measure, also moved closer to the central bank's goal of 2%.
• Friday's report was another piece of evidence supporting expectations among traders and economists that the Federal Reserve will cut interest rates in September.

The Federal Reserve's preferred measure of inflation slowed down in May, buoying hopes of interest rate cuts.

Prices as measured by the Personal Consumption Expenditures (PCE) index, rose by a negligible amount over the month. It was the slowest pace of inflation since November.

Year-over-year, prices have risen 2.6%, down from 2.7% in April. “Core” inflation, which excludes volatile prices for food and energy, slipped to 2.6% from 2.8% and closer to the Federal Reserve’s annual goal of 2%.

"It is just additional news that monetary policy is working—inflation is gradually cooling," said San Francisco Federal Reserve Bank President Mary Daly in an interview on CNBC after the numbers were released. "That's a relief for businesses and households who have been struggling with persistently high inflation. It's good news for how policy is working, but there's more work to do—not done yet."

All Signs Point to Easing Inflation

Friday's report backed up findings from the Consumer Price Index (CPI) earlier this month. Both measures showed inflation is likely still too hot for Fed officials and many household budgets, but it’s on the way down. The declines in the second quarter have also likely put to rest fears that inflation is flaring back up after increases in the first quarter.

"The May PCE and personal income report, as expected, indicates that personal spending, savings and inflation are normalizing after a long period of exuberant spending and high inflation that were turbo-charged by the drawdown of pandemic-related savings," wrote Nationwide Chief Economist Kathy Bostjancic.

Officials at the Federal Reserve pay closer attention to PCE rather than CPI when setting their influential fed funds rate, which affects interest rates on mortgages, credit cards, car loans and other kinds of borrowing.

So What's Next For The Federal Reserve?

Friday's report was a good sign for those hoping for relief from interest rates that are art two-decade highs. The Fed has kept the benchmark fed funds rate elevated for more than two years to push down inflation by discouraging borrowing and spending. However, the new PCE data supports economists' and traders' view that a central bank rate cut is imminent.

Traders are still firm in their belief that a rate cut is likely in September, pricing in a 68% chance, according to the CME Group’s FedWatch tool, which forecasts rate movements based on fed funds futures trading data. The chances were up slightly from the week before and up more than 20 percentage points from a month ago.

For Daly's part, she said central bankers remain data-dependent and didn't give an estimation of a policy path forward.

Market watchers believe the Fed is likely getting close to having the confidence it needs to start a rate-cutting cycle.

"Officials will want to see a few more encouraging inflation reports before beginning to cut interest rates, but they will not wait until inflation falls to their 2% target," wrote Michael Pearce, Deputy Chief U.S. Economist at Oxford Economics. "We still expect the Fed to begin cutting rates in September, and once per quarter thereafter."

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