Interest rate cut expectations are further strengthened! The inflation indicator most favored by the Federal Reserve is "just right": suggesting that inflation is not hot and the economy is not cold

According to the Zhitong Finance APP, the Federal Reserve's most favored inflation indicator—the so-called "Core Personal Consumption Expenditures Price Index" (Core PCE)—has been released. The July Core PCE and overall PCE year-on-year benchmarks align with economists' expectations, but have slightly warmed compared to previous months, reaching the highest level since February this year. However, the month-on-month figure remained flat at 0.3%, consistent with expectations and the previous value, indicating stable month-on-month inflation signals. Following the release of the latest PCE inflation data, market expectations for a Federal Reserve interest rate cut have increased, especially with the probability of a rate cut in September exceeding 90%. Futures traders are betting that the Federal Reserve will cut rates twice this year, each by 25 basis points—anticipating another cut in December.

Meanwhile, U.S. consumer spending in July recorded the largest increase in four months, demonstrating the resilience of American consumer demand. The Core PCE and consumer spending data significantly boost investors' expectations for a "Goldilocks" soft landing for the U.S. economy. The so-called "Goldilocks" macroeconomic environment refers to the U.S. economy being neither too hot nor too cold, maintaining moderate growth in GDP and consumer spending along with a long-term stable low inflation trend.

For the global financial markets, this latest PCE inflation data is precisely what individual and institutional investors want to see—this inflation data brings a market scale that is "just right." The overall PCE data report shows that U.S. inflation continues to stabilize, rather than showing the significant warming signs of tariff-driven inflation that investors have been anticipating this year. Meanwhile, consumer spending, which is crucial for expectations of U.S. economic growth, continues to show strong growth resilience.

The latest monthly Core PCE rose 0.3% month-on-month and 2.9% year-on-year, in line with expectations. The inflation-adjusted real personal consumption expenditures increased by 0.3% month-on-month, indicating that demand remains resilient. Therefore, interest rate futures pricing continues to point to a high probability of a Federal Reserve rate cut in September, and Fed Chairman Jerome Powell's remarks at the Jackson Hole global central bank meeting suggest a tendency for a rate cut in September. This PCE report reinforces the "Goldilocks" narrative of U.S. economic growth (decent growth, controllable inflation, and a shift towards looser policy).

A "Just Right" Inflation Report

According to the statistics released by the U.S. Bureau of Economic Analysis (BEA) on Friday, inflation-adjusted consumer spending increased by 0.3% month-on-month. This indicator is primarily boosted by rising U.S. incomes and driven by expanding demand for goods.

The so-called Core Personal Consumption Expenditures (Core PCE) price index (excluding food and energy items, which is the preferred indicator of the Federal Reserve) rose 0.3% month-on-month compared to June, in line with market expectations. Year-on-year, this indicator increased to 2.9%, the highest since February, but consistent with general market expectations. Overall PCE increased by 0.2% month-on-month and 2.6% year-on-year, both in line with market expectations and showing signs of stabilization in the overall PCE indicator

Latest data shows that the rebound in service prices may exacerbate concerns about rising inflation expectations, while the tariff policy led by U.S. President Donald Trump is gradually transmitting through the economy. Currently, Americans continue to spend, but against the backdrop of rising prices and a weakening job market, although consumer spending shows remarkable resilience at present, it remains unclear how long this momentum can last.

The latest rise in U.S. PCE inflation is driven by rising service costs, which have seen the largest increase since February. This includes a surge in portfolio management fees, reflecting the incredibly strong bull market in the U.S. stock market over the past few months—the S&P 500 index has repeatedly set new historical highs. The cost of entertainment services (including live sports events and entertainment activities) has also increased.

The PCE data report shows that a closely watched core service inflation indicator, excluding energy and housing, rose by 0.4%, marking the largest increase in five months. Meanwhile, the cost of goods unexpectedly fell sharply.

To protect American consumers and not harm their affordability, some companies have rushed to import goods into the U.S. before tariffs take effect, while others have diversified their supply chains or chosen to sacrifice their profit margins. However, as most tariffs are now in place, many companies emphasize the necessity of passing on more additional costs to consumers.

The acceleration in consumer spending is largely attributed to consumers increasing their purchases of goods, particularly durable goods such as automobiles, household furniture, and sporting equipment.

Despite the labor market, a major engine of household demand, slowing down, promotional events from U.S. retail giants like Amazon's Prime Day continue to provide a strong boost to goods spending.

Retailers from Walmart Inc. to Home Depot Inc. and Dick’s Sporting Goods Inc. have expressed optimism about demand resilience. That said, consumer confidence remains relatively low as American consumers generally expect Trump's tariff policy to ultimately drive up prices and face a deteriorating job outlook.

Without inflation adjustment, U.S. wages and salaries surged by 0.6% in July, the largest increase since last November. Real disposable income rose by 0.2%. The savings rate remained unchanged.

U.S. government data to be released next week will provide more clues about the direction of the labor market. Economists currently expect job growth to fall below 100,000 for the fourth consecutive month, marking the weakest period of non-farm employment data since 2020. The unemployment rate is expected to rise slightly in August.

The Federal Reserve's rate cut in September is "just waiting for the official announcement," but the subsequent rate cut process remains quite suspenseful. After the release of the PCE data report, the three major U.S. stock index futures narrowed their declines, U.S. Treasury yields rose, and the dollar remained strong. Traders generally expect the Federal Reserve to cut interest rates during its meeting on September 16-17.

At last week's annual Jackson Hole meeting of the Federal Reserve, Chairman Jerome Powell cautiously opened the door to a rate cut next month against the backdrop of rising risks in the labor market, although he noted that the consumer price impact of the tariff policies led by Trump "is becoming increasingly clear."

However, before that meeting, Federal Reserve policymakers will receive more reports on inflation and the labor market, which are crucial for whether to officially restart rate cuts in September and the expectations for cuts in October and December.

Federal Reserve Governor Christopher Waller, who has permanent voting rights on monetary policy during his term, reiterated his call for a rate cut, stating he would support a 25 basis point cut in September and expects the Fed may further lower rates in the next three to six months.

As of Friday, following the release of the PCE data report, the pricing trends in the interest rate swap market indicated that the probability of a rate cut by the Fed in September rose from 80% to as high as 90%, and by the end of 2025, the market fully priced in a total of two rate cuts, each by 25 basis points. By September 2026, the market pricing showed expectations of up to 125 basis points of easing policy.

Kevin Gordon, a senior investment strategist at Charles Schwab, stated that Powell's Jackson Hole speech "helped the market almost confirm the rate cut signal for September, although it has not yet been officially confirmed, this does not necessarily mark the beginning of a comprehensive rate-cutting cycle."

Joe Brusuelas, chief economist at RSM US LLP, wrote in a report to clients that if hiring activity moderately rebounds while inflation continues to rise, it would point to a scenario where the Federal Reserve "cuts rates only once in September and then pauses to observe."