CPI Report Clears the Way for a Fed Quarter-Point Rate Cut

With the August Consumer Price Index report in the rearview mirror, the path appears clear for the Federal Reserve to cut interest rates when it meets next week.

The report was mostly positive about inflation trends, with a few caveats. The Bureau of Labor Statistics reported that the CPI increased 2.5% in August from year-ago levels—a decrease from July’s 2.9% rate and just below forecasts for a 2.6% increase. Core CPI, which excludes volatile food and energy costs, rose 3.2% in August over the last 12 months after rising 3.2% in July.

However, on a monthly basis, core CPI rose 0.3% in August, just above the 0.2% increase economists had forecast.

“Today’s inflation data was slightly higher than expected. But it’s not nearly enough to dissuade the Fed from cutting interest rates,” says Preston Caldwell, Morningstar’s chief US economist.

August CPI Report Key Stats

• CPI rose 0.2% for the month, as it did in July.
• Core CPI climbed 0.3% after rising by 0.2% in July.
• CPI rose 2.5% year over year after rising by 2.9% the prior month.
• Core CPI rose 3.2% from year-ago levels after rising 3.2% in July.

The above-forecast reading in core inflation was largely due to higher housing costs. “The index for shelter rose 0.5 percent in August and was the main factor in the all-items increase,” the BLS said.

“Housing is the sole remaining driver of our inflationary worries,” Caldwell says. “The housing inflation data is somewhat volatile on a month-to-month basis, so we shouldn’t take the August uptick too much to heart,” he explains. “By any measure, market rent growth (we estimate it at 2% year over year) is lower than the housing component of inflation, which is running at 5% year over year. As long as this remains in place, housing inflation has to inevitably fall.”

Within the report, food prices increased 0.1% in August after growing 0.2% in July. Food-at-home prices stayed the same over the month, while food-away-from-home (restaurant) prices increased 0.3%. Energy prices declined over the month, down 0.8% overall after holding steady the prior month. Utility (piped) gas service prices fell 1.9%, fuel oil prices fell 1.9%, gasoline prices declined 0.6%, and electricity prices fell 0.7%. Shelter prices increased 0.5% after rising 0.4% in July.

“Durables prices remain in substantial deflation, falling at a 4.6% annualized rate in the past three months,” Caldwell says. “This month, while we did see a hefty drop in used car prices, durables prices excluding vehicles also fell by 0.7%. For example, TVs fell by 2.8%, and smartphones by 1.4%.” He notes: “On the services side, we saw a 3.9% rebound in airline prices, after several months of steep declines. Other components of core services were generally mild in inflation in August.”

The news should be better with the Fed’s preferred measure of inflation, the Personal Consumption Expenditures Price Index. As part of its mandate, the Fed targets a 2% annual inflation rate in that index. “Core PCE inflation should likely still come in at around 0.2% month over month for August, undershooting core CPI significantly because of its lower weight to housing,” Caldwell says. “That would translate into a 2.0% annualized rate in the last three months, 2.4% in the last six months, and 2.7% year over year. Core PCE excluding housing would stand at 2.1% year over year.”

How Much Will the Fed Cut Rates?

Attention now turns to the Federal Reserve’s two-day policy meeting next week. Investors are widely expecting the central bank to cut interest rates for the first since it began its aggressive campaign to stamp our surging inflation with tighter monetary policy in March 2022.

In the markets, the debate has been over how much the Fed will cut rates. Some in the bond market had been looking for the central bank to take an aggressive stance and lower its rate target by half a percentage point from its current 5.25%-5.50% range. But investors now appear to be leaning toward a quarter-point cut when the decision is announced next Wednesday afternoon.

“With core CPI inflation coming in hotter than expected but the impact on core PCE likely to be more muted, today’s data slightly diminishes the odds of a 50-basis-point rate cut in the Fed’s September meeting,” Caldwell says. “But we already thought the odds were low for a 50-point cut. Today’s data does nothing to dissuade the Fed from implementing a 25-point cut, which is our expectation. The Fed is not far from achieving its target of 2% PCE inflation. But the risks to the full employment side of its dual mandate have heightened.”