Inflation numbers this month were even better than reported

You have probably heard that we recently received two positive inflation reports. Core CPI inflation is at 3.3%, and core PCE inflation was announced to be 2.6% today.

What’s the difference between CPI and PCE?

CPI inflation is what you likely learned in high school economics. It is calculated using a “basket” of goods weighted to reflect a typical consumer’s behavior, updated every two years.

PCE inflation is slightly different. It uses a chain-weighted price index and weights based on actual consumption. The key difference is that PCE considers consumer substitution. For example, if whole milk doubled in price but fat-free milk remained the same, we would expect some consumers to switch to fat-free milk, lowering the inflation effect. CPI, however, would show a higher inflation rate since it doesn't account for this change in behavior. Due to this substitution effect, the Federal Reserve prefers to look at the PCE inflation rate.

So why were this reports so good?

Apart from the good 12-month numbers, we should also examine more recent changes. Below are charts showing the annualized change in PCE and CPI, with different lines for annualized 1-month, 3-month, 6-month, and 12-month inflation.

Focusing solely on the 12-month inflation during disinflation is looking at a lagging indicator. Instead, you should watch the annualized 3-month inflation rate to understand where we are heading. When examining the annualized 1-month and 3-month rates for both CPI and PCE, we are nearly at the 2% Fed target. That’s significant! While these metrics are more volatile than the 12-month rate, they suggest we are nearing the end of this inflation battle.

What does that mean for interest rates?

Interest rate futures contracts now show a 90% likelihood for a rate cut in September. By December 2024, most traders expect Fed rates to be at 4.5%, 0.75% lower than today.

Looking further into the future, there's more uncertainty, but traders currently expect Fed rates could be as low as 4% by April next year. That would be 1.25 points lower than today and would relieve pressure on many medium and longer-term consumer loans, such as mortgages and car loans.

If these expectations hold, we could be on track for a normalized Fed posture by mid-2025. If that happens, mortgage rates and auto loan rates could return to historic averages. While I don’t see mortgage rates falling back to 2% without a recession, we could be on track for a typical 5% mortgage rate by mid to late 2025.

Going Forward

If you are preparing for a major purchase, such as a new car or buying a home, these inflation reports are positive signs that interest rates could start to come down at last.

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