Inflation cooled in August, Fed remains ready to cut interest rates

Inflation continued to decline in August, allowing the Federal Reserve to cut interest rates for the first time since early 2020 at its meeting next week.

But beneath the surface, signs of stubbornness were emerging, prompting investors to place higher bets that central bankers would cut borrowing costs by a quarter of a percentage point from the current 5.33 percent – rather than the larger half a percentage point that some had previously thought possible.

The general consumer price index rose 2.5 percent in August from a year earlier, a significantly lower inflation rate than the 2.9 percent in July and a sharp decline from the 2022 peak of 9.1 percent.

But the number that caught Wall Street's attention on Wednesday was a monthly “core” reading, which shows how much prices rose between July and August after stripping out food and fuel prices, both of which can be volatile. And the reading rose 0.3 percent, slightly more than economists expected.

The details made the move important: It came as a gauge of home prices proved surprisingly stubborn. Housing costs account for a large portion of overall inflation, so if they don't cool as expected, they could prevent the pace of price increases from fully returning to the Fed's target.

However, this complication was not enough to change the overall situation. Inflation has been gradually slowing for some time, paving the way for a change in Fed policy. Central bankers are trying to find a balance that will allow them to completely contain rapid price increases without driving the economy into the abyss.

“I still think they have enough confidence to continue cutting rates, but that suggests: Don't go too fast here,” said Laura Rosner-Warburton, senior economist and founding partner at MacroPolicy Perspectives. “We're not quite out of the woods yet.”

High interest rates act as a brake on the economy. They slow economic activity, and when demand falls, it becomes harder for companies to raise their prices. But Fed officials want to proceed cautiously. If rates remain too high for too long, it could slow conditions too much, boost unemployment and risk a recession.

Fed officials don't want to make too many cuts too quickly when there's a chance price increases aren't fully under control, because that could reheat the economy and make inflation a permanent problem. But they also don't want to delay and risk the health of the labor market.

That's why policymakers are closely watching upcoming inflation and employment data and considering how quickly to move both at their two-day meeting that ends next Wednesday and in the months that follow.

Next week, policymakers will provide an overview of their plans for the future when they release new quarterly economic forecasts, which will provide a broad direction for interest rate developments.

The Fed's move next week will mark a turning point in the economy and the clearest sign yet that central bankers are confident they can win the battle against inflation, even if victory is not yet complete.

After initially picking up in early 2021, inflation has now been cooling for more than two years and is finally approaching a normal pace.

Officially, Fed officials are aiming for an inflation rate of 2 percent, although they define this target using the price index for private consumption expenditures. This value uses some data from the current consumer price index, but is published with a longer delay. This value has also weakened.

Rosner-Warburton expects housing costs to fall in the coming months. But there could be setbacks along the way: for example, she expects used car prices to rise again in the fall.

“The direction of travel is still clear,” she said. “It's about the speed and whether it's in a straight line.”

If price increases return to the Fed's targets, consumers may begin to feel like they are catching up. By several measures, wage growth has been faster than price increases for more than a year.

This is good news for the Biden administration, which has struggled to take credit for its economic successes – including a stable labor market – as rising prices undermined consumer confidence.

“As inflation returns to near-normal levels, it is important to focus on maintaining the historic gains we have made for American workers during this recovery,” Lael Brainard, director of the White House National Economic Council, said in a statement following the report.