A leading indicator of inflation just posted a surprise drop in May, raising cautious optimism that the U.S. economy is finally escaping the inflationary spiral.

According to the Department of Labor, the Producer Price Index (PPI) declined by 0.2% from April. That was the largest monthly drop since October. On an annual basis, the PPI rose by 2.2%, which was well below forecasts.

The PPI is considered a leading indicator of inflation because it reflects the costs incurred by manufacturers and wholesalers, which are often passed on to final prices paid by consumers.

The report showed that the prices of goods used earlier in the production pipeline declined by 1.5%, the largest drop since 2022.

The PPI was the second data point this week to show that inflation was gradually cooling. The more closely watched Consumer Price Index (CPI) edged up by 0.2% from April and 3.3% year-over-year—both lower than expected.

Economists say the latest reports should reassure the Fed that its interest-rate policy is working. Some even suggest that a rate cut could be on the table as early as the fall.

Two steps in the right direction

According to Bill Adams, chief economist at Comerica Bank, “Inflation took two steps in the right direction last month after surprising to the upside in early 2024.”

“The PPI report reinforces expectations for a soft print of the Fed’s preferred measure of inflation," said Adams, referring to the core PCE index.

Moderating core PCE would go a long way in convincing the Fed that inflation is heading in the right direction. As Creditnews reported, the index spiked from 2% to 3.7% in the first quarter.

“This kind of (inflation) performance, coupled with continued favorable performances over the next few months, is what is needed, in our opinion, for a September Fed rate cut to occur,” said Sam Bullard, a senior economist at Wells Fargo.

Although the Fed has signaled that only one rate cut is expected this year, markets are still clinging to the possibility of multiple reductions. CME Group’s FedWatch Tool shows a more than 67% chance that rates will be lowered at least two times in 2024.

The Fed will hold its next policy meeting on July 30-31, followed by the all-important Sept. 17-18 meeting, when its officials will provide an update on their inflation and interest rate forecasts.