Inflation data fuel markets but economists remain cautious

The financial markets shifted into risk-on mode following inflation data Friday that capped a week of good news for the markets and the economy.

While it’s still too early to speculate on how the Federal Reserve might respond when it meets in September, the message is clear to financial advisors and market watchers: U.S. inflation is on a slowing trend.

“Everything this week has been good for the markets and has raised the probability of a soft landing,” said Jeanette Garretty, chief economist at Robertson Stephens.

“Right now, this is an incredible economy to be able to go through 550 basis points of tightening in the fastest-ever period of time and still moving along the way it is,” she added.

In midday trading Friday, the equity markets rallied following an update on the personal consumption expenditures price index, which fell to its lowest level in two years, indicating the Fed might be gaining some ground in its battle with inflation.

The PCE, a broad measure of personal consumption expenditures closely watched by the Fed, was up 3% in June over the same period a year ago. That compares to the 3.8% year-over-year increase in May.

On a monthly basis, prices climbed 0.2% from May to June.

Core PCE, which excludes the more volatile food and energy prices, was also up 0.2% in June, but slowed on an annualized basis to 4.1% from 4.6%. Analysts were forecasting core PCE to come in at the slightly higher level of 4.2%.

Core PCE is now at its lowest point since September 2021.

“It is a positive and meaningful step because it shows inflation is moving in the right direction,” said Seamus Smyth, chief economist at Virtus Investment Partners.

Smyth acknowledged the market’s enthusiastic response to the PCE data but said the report doesn’t completely take another rate hike off the table.

“If you think it will be a real and lasting move down for inflation that will enable the Fed to be less aggressive, it can lead to an allocation to riskier assets,” he said.

The next hurdles will be the two inflation reports to come between now and the Fed’s next meeting in September.

“The other side of this is some of the recent data on employment and economic growth that have been on the firmer side, which is what the Fed wants to see,” Smyth said. “The Fed is trying to balance out those against the inflation data.”

Quincy Krosby, chief global strategist for LPL Financial, noted that the PCE report "helped push the policy-sensitive two-year Treasury yield lower as well, in a sign that the Treasury market perceives that the Fed's campaign to quell inflation is working."

“Inflation, at its core, remains too high and above the Fed's target for restoring price stability,” Krosby added. “With 54 days remaining until the next Fed meeting, there will be a raft of significant inflation-related data released, but the most important for indications suggesting that another rate hike should be expected will be squarely focused on the core of both the CPI and PCE.”

Ryan Brandham, head of global capital markets for North America at Validus Risk Management, is also not convinced the current level of inflation is enough to pause the Fed in September.

“This result contributes to the evidence that inflation is coming under control in the U.S., and further strengthens the argument of those urging the Fed to pause rate hikes,” he said. “At this point, this is not enough to rule out a rate hike in September. More data is needed between now and then to see how the outlook evolves.”