The Fed's "favorite" inflation gauge will be released on Friday, will it support a significant rate cut later this year?

The Federal Reserve's favorite inflation indicator, the core PCE price index, is set to be released this Friday evening, providing further key clues for the Fed's rate cut.

The market generally expects that the US August PCE price index will fall to 2.3%, the lowest level since the beginning of 2021, but the core PCE price index will rise by 0.1% to 2.7% from July. Economists believe that the rise in core inflation is due to an unexpected increase in housing costs, but rents and house prices are stabilizing, and inflation in other major areas has eased. Therefore, the August inflation data may support further rate cuts by the Federal Reserve.

On the other hand, investors are quietly preparing for the return of inflation, believing that the road to "fighting inflation" is long and arduous. Data shows that investors' average inflation expectations for the next 5 years are 2.04%, higher than the 1.86% at the beginning of the month. The Fed's recent pace of easing by 50 basis points may reignite inflation risks in the second half of the year.

According to the latest Bloomberg survey:

The US August PCE price index is expected to rise by 2.3% year-on-year, touching the lowest level since the beginning of 2021, a 0.2 percentage point decrease from the previous value of 2.5%, with a month-on-month increase expected to fall from 0.2% in July to 0.1%.

The core PCE price index is expected to rise by 2.7% year-on-year, up 0.1 percentage point from the previous value of 2.6%, with a month-on-month increase expected to remain at 0.2%.

Housing Costs Exaggerating Inflation? August Data May Support Further Rate Cuts

The market expects the US August PCE price index to fall to 2.3%, reaching the lowest level since the beginning of 2021. Some economists even predict that the Fed will achieve its 2% inflation target in January or February next year. Gregory Daco, Chief Economist at Oxford Economics, said:

We expect the PCE to be around 2.5% by the end of the year, and then approach the Fed's 2% target in early 2025.

However, on the other hand, the market expects core inflation to rise: the core PCE price index is expected to increase from 2.6% to 2.7% in August. Some economists explain that the most likely reason for the increase in inflation is the unexpectedly sharp increase in housing costs last month. But recent trends indicate that rents and house prices have stabilized, and inflation may further slow down in the coming months.

Some senior Fed officials, including Fed Chairman Powell, believe that the housing index exaggerates the US inflation rate. Housing is the largest component of the main inflation index in the US.

Analysis suggests that apart from housing, inflation in most areas has eased. The upcoming PCE inflation data may show a cooling of inflation and support further rate cuts by the Fed. As long as rents continue to decline, Fed officials are prepared to overlook the expensive housing component to better understand the potential inflation rate.

Economists at Nationwide wrote in a report:

Although there may be some bumps along the way, inflation seems to be moving towards the Fed's 2% target at the moment

However, investors quietly prepare for the return of inflation

Concerns about a resurgence of inflation in the current market have not dissipated.

As of Tuesday, both inflation swaps and U.S. Treasury inflation-protected securities suggest that inflation may linger above the Federal Reserve's 2% target in the coming years. According to the latest data from the St. Louis Fed, the U.S. five-year breakeven inflation rate (reflecting investors' expectations of the average inflation rate over the next five years) recently climbed to 2.04%, after hitting a near four-year low of 1.86% earlier this month.

The inflation swap market also shows a similar trend. Tradeweb data shows that as of Tuesday, the one-year swap inflation rate linked to the overall CPI is 2.028%, while the five-year swap rate is 2.333%, both rising from their lows in September.

The Federal Reserve cut its policy rate target by 50 basis points last week, further easing monetary policy. Tim Murray, capital market strategist at T. Rowe Price, stated that inflation may reignite in the second half of this year:

They would rather gradually reduce inflation to avoid an economic recession, but this path means that inflation risks still exist. Inflation not only takes longer to dissipate, but as the second half of the year approaches, it may be reignited.

Even some senior Federal Reserve officials have expressed concerns that inflation has not been completely defeated. Bowman, the only Fed governor who voted against the rate cut last week, stated in a release that such a dramatic first rate cut may unnecessarily reignite inflationary pressures.