The Fed’s most trusted inflation gauge falls to lowest level since 2020

The Fed’s favorite inflation measure has decelerated to its slowest pace since late 2020, raising cautious optimism that the central bank's battle against rising costs reached a turning point.

According to the Bureau of Economic Analysis, the core Personal Consumption Expenditures (PCE) index—a measure of inflation that strips away food and energy costs—increased by just 0.08% in May.

The increase was so small that government economists had to round it up to 0.1%. But the actual rate of growth was the smallest in three and a half years.

Compared to a year earlier, core PCE increased by 2.6%, which was in line with expectations. It was also the smallest annual increase since March 2021.

The latest PCE data is significant because it suggests that consumer price growth is slowly falling back toward the Fed’s 2% target.

Economists think the latest PCE release confirms a growing list of evidence that inflationary pressures are moderating after an unexpected resurgence earlier in the year.

“This is the kind of good data that will persuade the Fed that inflation is heading back to normal,” said Bill Adams, chief economist at Comerica Bank.

The report should also provide the Fed with much-needed breathing room as it navigates its next policy decision.

The Fed sees progress despite criticism

Economists haven’t shied away from criticizing the Fed for its “unscientific” inflation target and obsession with prices. But according to San Francisco Fed President Mary Daly, the latest report should silence those critics.

“It is just additional news that monetary policy is working, inflation is gradually cooling,” Daly said in a CNBC interview. “That’s a relief for businesses and households who’ve been struggling with persistently high inflation.”

Some economists say the latest PCE report puts multiple rate cuts back on the table.

“This was a very Fed-friendly report that should keep the September rate cut in play, while at the same time increasing investor confidence that moderate economic growth can be maintained even as rates stay higher for longer,” said Scott Anderson, the chief U.S. economist at BMO Capital Markets.

Earlier in June, the Fed tried to temper expectations about interest rates by penciling in just one rate cut this year. It marked a major u-turn from just three months earlier when central bankers forecasted three rate cuts.

Despite the revised forecasts, Wall Street "oddsmakers" are still pricing in multiple cuts in 2024.

According to CME Group’s FedWatch Tool—which infers interest rate expectations from derivative instrument prices—there’s a more than 65% chance that the Fed’s rate will be below 5% before Dec. 31.