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Fed gets a break with cooling inflation, but when will interest rates drop?

U.S. Federal Reserve officials received promising data last Friday suggesting a cooling inflation trend, providing some relief following stronger-than-expected price increases earlier this year. However, while monthly progress is evident, reaching the Fed's 2% inflation goal will be a lengthy journey, complicating decisions on when to reduce interest rates.

San Francisco Federal Reserve Bank President Mary Daly highlighted the progress in an interview with CNBC shortly after the Bureau of Economic Analysis report showed no inflation rise from April to May. "We are getting evidence that (policy) is tight enough," Daly said. "It's really challenging to look anywhere and not see monetary policy working: we have growth slowing, spending slowing, the labor market slowing, inflation coming down."

Despite this progress, there's still much work ahead. The personal consumption expenditures price index rose 2.6% from a year ago, still above the Fed's 2% target.

The Fed has maintained its policy rate in the 5.25%-5.5% range since last July, likely marking the final rate hike of an aggressive campaign started in March 2022 to combat high inflation. No rate cuts are expected until there is more confidence that inflation is sustainably moving towards the 2% goal.

Friday's inflation figures have led traders to bet on a higher chance of a rate cut in September, with another anticipated in December. "May's inflation print was well below the threshold the Fed needs to be comfortable and breaks the string of high inflation prints we've seen since the start of the year," noted Natixis economist Christopher Hodge.

However, the optics for rate cuts could be challenging. Even if monthly inflation aligns with the Fed's 2% target, it will take until the end of the year to see this reflected in the year-over-year readings due to last year's low inflation rates.

What are your thoughts on the latest inflation data and the Fed's potential rate cuts? Share your thoughts in the comments below!

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