PCE inflation cooled in May, raising hopes for lower interest rates

PCE inflation cooled in May. Is this the 'good data' the Fed is looking for?

June 28, 2024 4:12 PM

The personal consumption expenditures index, a key measure of rising prices, cooled in May 2024.

At Thursday night's presidential debate, one topic that came up again and again was inflation.

"Inflation's killing our country. It is absolutely killing us," former President Donald Trump said at one point.

In reality, inflation has been declining for months, albeit slowly. And the morning after the debate, more evidence of this emerged: a downtick in the personal consumption expenditures index. In May, the year-on-year change in the PCE was 2.6%, down from 2.7% in April.

Perhaps even more important, "core PCE" — which strips out volatile food and energy prices — also declined, from 2.8% to 2.6%.

That's significant because core PCE is the Federal Reserve's preferred measure of inflation, and the Fed has insisted that it needs more evidence of cooling prices before it begins cutting interest rates.

"We will need to see more good data to bolster our confidence that inflation is moving sustainably toward 2%," Chair Jerome Powell said after the Fed's meeting earlier this month.

That "2%" is the target the Fed has in mind for core PCE, which has been moving steadily toward it this year. In January, core PCE was at 2.9%. It then sank to 2.8% in February and hovered there through March and April. In May it finally moved down again — a reassuring sign for many analysts that inflation is still moving in the right direction.

The U.S. stock market certainly appeared to take the news that way. On Friday morning, the Nasdaq and S&P 500 both responded by soaring to record highs.

But in the longer term, what does this mean for the economy? The new PCE data may clear the way for the Fed to lower rates — but when? Meanwhile, consumer spending rose more slowly than expected. That puts less upward pressure on inflation, but could it also be a worrying sign for the broader economy? And for investors and their financial advisors, which assets are likely to benefit from this disinflation, and which ones will take a hit?

For answers, Financial Planning turned to some of the sharpest analysts on Wall Street. Here's what they said:

Rising hopes for lower rates

Jeffrey Roach, chief economist at LPL Financial

"The soft inflation data will build the case that the Fed can start cutting rates in the coming months. As long as incomes grow at a healthy clip, consumers will keep spending. The key is the labor market, and so now we should shift our attention to next week's nonfarm payroll release for a fresh look into the job market."

Soft landing in sight

Bret Kenwell, U.S. investment analyst at eToro

"The May PCE report is good news and puts us one step closer — albeit a small step — to a soft landing. Following a cooler-than-expected CPI [consumer price index] report earlier this month, inflation continues to inch its way toward the Fed's long-term target of 2%. If we keep making progress on inflation without sacrificing the economy or the labor market, the Fed can achieve a soft landing — although that outcome is still to be determined.

"The in-line PCE report for May moves the Fed one step closer to cutting rates in the second half of the year. Absent any meaningful upside surprises in the CPI and PCE reports in the summer could set the stage for a September cut and potentially put the Fed on track to cut rates more than once this year. On the other hand, a few hotter-than-expected reports will likely delay the Fed's first rate cut of this cycle.

"If the market gains confidence in one or several second-half rate cuts, it could benefit small- and mid-cap stocks, which have lagged its large-cap peers through the first half of 2024. It could also benefit cyclical stocks and rate-sensitive sectors like real estate and utilities."

A Goldilocks scenario

Gene Goldman, chief investment officer at Cetera Financial Group

"Taken together, the slower inflation trend and a weaker consumer suggests that the economy continues its glide into a soft landing. On the other hand, we do not see a recession in the next twelve months as the labor market remains strong, consumer debt levels are manageable, and areas currently in recession, housing and manufacturing, are stabilizing, albeit at lower levels.

"The PCE report shows a return of the disinflationary trend and may prove that the Fed's June Dot Plot projection of year-end core PCE inflation of 2.8% may be too high. Unlike the Dot Plot that suggested just one rate cut, this suggests that two rate cuts, and maybe even three rate cuts, could be in the cards for 2024.

"While the Goldilocks scenario remains in place and a soft landing is likely, it is clear that the consumer is slowing. This is a trend that the markets had really not focused too much on until recently. The markets will likely experience significant volatility if the consumer, representing two-thirds of our economy, worsens further."

Cuts are coming

Brian Rose, senior U.S. economist at UBS Financial Services

"Core PCE inflation slowed to 2.6% year over year in May, the lowest in more than three years and down from the peak of 5.6%. Real disposable income showed a strong 0.5% month-over-month increase, helped by the big rise in nonfarm payrolls in May, higher average hourly earnings and slower inflation. …

"Next week, key data releases include the labor report for June and JOLTS [Job Openings and Labor Turnover Survey] data on job openings for May. Bad news from the labor market could add some urgency to the Fed as it considers the timing of rate cuts. We maintain our view that the Fed will start cutting rates in September. This should lead to lower bond yields by year-end, as markets are likely to anticipate further rate cuts in 2025. In our investment strategy, we maintain a preference for quality bonds."