The Fed is close to overcoming inflation, but needs to be wary of a potential pitfall!

The Federal Reserve's favorite inflation gauge may show that the pace of price increases in August remains slightly above the 2% target level, but the overall downward trend proves that further rate cuts are justified. This was the consensus among Wall Street economists before the release of the US consumer spending and inflation report on Friday in August.

The US August Personal Consumption Expenditures (PCE) price index is expected to rise by 0.1% month-on-month, while the core PCE, which excludes volatile food and energy prices, is expected to rise by 0.2% month-on-month.

Economists at Nationwide wrote in a report to clients, "Although there may be some bumps on the road to anti-inflation, inflation now appears to be on a sustainable path towards the Fed's 2% target."

Some economists and Fed officials themselves believe that core inflation in August may also rise slowly by 0.1%. This will support the Fed's decision last week to cut policy rates by 50 basis points for the first time since 2020.

A potential uncertainty factor is the annual revision of PCE data by the government. However, economists doubt whether there will be any significant surprises.

Economists expect that Friday's PCE report may show that the year-on-year growth rate of overall inflation may decrease from 2.5% to 2.3%, reaching the lowest level since early 2021. Some economists even predict that the Fed may reach its target by January or February next year.

Gregory Daco, Chief Economist at EY Parthenon, said, "We expect PCE to reach around 2.5% by the end of the year, and then move towards the Fed's 2% target in early 2025."

On the other hand, the year-on-year growth rate of core inflation in August may rise slightly from 2.6% to 2.7%. It is certain that this is not good news, but any negative reaction on Wall Street will depend on the reasons driving this indicator up.

Economists say that the most likely influencing factor is the unexpected sharp increase in housing costs last month. However, recent trends indicate that rents and house prices have stabilized, which should lead to further easing of inflation in the coming months.

Some senior Fed officials, including Powell, believe that housing exaggerates the US inflation rate. The sector is the largest single component in the government's main inflation index.

However, the benchmark 10-year US Treasury yield has risen sharply after the Fed's significant rate cuts, which may complicate the partial cooling of housing inflation.

The rise in benchmark yields may mean that it will take some time to reverse the "lock-in effect" in the real estate market - millions of homeowners who have secured ultra-low mortgages during the pandemic are still reluctant to put their properties on the market.

Bret Barker, Co-Head of Global Rates at TCW, said that the 10-year US Treasury yield needs to fall to 3% or even lower to trigger a significant wave of refinancing However, as long as rents continue to decline, Federal Reserve officials are prepared to overlook higher housing inflation in order to better understand the potential inflation rate.

Atlanta Fed President Bostic wrote in an article on Monday, "This is somewhat of a puzzle, and I hope that some intermittent initial signs of a decline in housing price increases in the PCE index will soon be consolidated."