Improvement in U.S. Inflation Eases Pressure on Federal Reserve Policy



Amid lingering concerns over potential rate hikes by the Federal Reserve (Fed), the stock market's outlook remains uncertain. Market sentiments currently project a mere 12% probability of a 25 basis point rate increase during the September 20 Federal Open Market Committee (FOMC) meeting, while the odds rise to 37% for a similar rate hike at the November 1 FOMC meeting.

The stock market's trajectory towards positive gains seems contingent on the dissipation of rate hike apprehensions, a diminishing possibility of a banking crisis, and a nearly eradicated risk of a U.S. economic downturn.

Today's release of the Personal Consumption Expenditures (PCE) deflator report brings a glimmer of hope, particularly for the Fed, given its reliance on this metric as a gauge of inflation. The Fed's stance on further interest rate hikes pivots on the trajectory of inflation, and a key factor in this decision-making process. To restore market confidence and stave off concerns in the bond market, the Fed aims to reel inflation back to its 2% target.

Encouragingly, the most positive takeaway from the July PCE deflator report is the 3-month annualized deflator figures, which have descended to post-pandemic lows. The nominal deflator and the core deflator both stood at +2.1% and +2.9% respectively. Notably, the 3-month annualized core deflator of +2.9% still overshoots the Fed's 2% target, but marks a significant retreat from the four-decade high of +6.7% reported in June 2021 during the height of pandemic-induced price surges. This particular metric examines inflation trends over the past quarter, which are then annualized.

Further positive signs emerged within the deflator report, where both the nominal and core deflators registered a modest monthly increase of +0.2%. This sequential uptick is the smallest observed since late 2020.

While the year-on-year figures in the deflator report showed some regression, the magnitude was insufficient to warrant significant concern. The July PCE deflator report indicates a +3.3% increase from June's two-and-a-quarter-year low of +3.0%. However, this remains notably below the four-decade peak of 7.0% recorded in June 2022. Similarly, the core PCE deflator for July stood at +4.2%, a step up from June's year-long low of 4.1%, yet remains substantially below the four-decade high of +5.4% reported in February 2022.

Market optimism revolves around the anticipation that U.S. inflationary pressures will continue to alleviate in the coming months. Should this trend persist, it could pave the way for the Fed to conclusively terminate its aggressive rate-hike strategy, potentially triggering a sustained upturn in the stock market.

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