The Fed’s inflation battle may have just turned a corner

The Fed’s preferred measure of consumer prices cooled as expected in April, raising cautious optimism that the U.S. central bank got the better of inflation.

According to the Department of Commerce, the core Personal Consumption Expenditures (CPE) index, which excludes food and energy, increased by 0.2% in April, down from a 0.3% pace the previous month.

On an annual basis, core PCE rose 2.8%, unchanged from March.

While the monthly change doesn’t seem like much, it signals that “disinflation momentum resumed in April,” said EY-Parthenon chief economist Gregory Daco.

“Slower consumer spending growth, reduced markups, declining rent inflation, and moderating wage growth” will keep inflation from accelerating further, Draco explained.

Although personal spending increased in April, it was entirely driven by inflation as Americans spent more for the same items. Adjusted for inflation, spending dropped by 0.1% in April, following a 0.4% uptick in March.

On the surface, the April data suggest that the Fed is making progress. But economists warn that anyone who cheered the latest report should be careful what they wish for.

A difficult wager for the Fed

Cooling prices should give the Fed more reason to cut interest rates. But if inflation slows too quickly, the central bank could have a bigger problem on its hands.

Chris Zaccarelli, the chief investment officer at Independent Advisor Alliance, said, “We are in a be-careful-what-you-wish-for moment” regarding inflation and the Fed.

“If [...] the Fed is able to cut slowly as a result, then that will be good for markets. However, if consumer spending—and the economy—slows too quickly, then corporate profits and stock prices will go down much more quickly than the Fed will be able to cut rates,” he said.

Several notable economists think the Fed has boxed itself in a corner with its inflation policy. By targeting 2% inflation, the central bank lacks the flexibility to chart a different path to avoid recession.

According to Allianz chief economist Mohamed El-Erian, the Fed might not be able to cut interest rates in time to “avoid significant economic and financial damage.”

Meanwhile, Nobel Prize-winning economist Joseph Stiglitz thinks interest rates are already too high.

“Everybody realizes that we don’t have runaway inflation,” Stiglitz said. “There’s no economic science” behind a 2% inflation target.

The Fed is unlikely to make any policy changes at its upcoming policy meeting in June. However, the market is betting on a rate cut sometime in the fall.