Is Inflation Cooling Down? Fed's Preferred Inflation Indicator Shows Promising Signs

Diccon Hyatt, a seasoned financial and economic journalist, has extensively covered the pandemic-era economy with hundreds of insightful articles over the past two years. He specializes in breaking down complex financial concepts into clear language, highlighting their effects on personal finances and market trends. His experience includes work at U.S. 1, Community News Service, and the Middletown Transcript.

Key Insights

• The Federal Reserve’s preferred inflation measure, Personal Consumption Expenditures (PCE), indicates inflation eased in January.
  
• Annual inflation rose by 2.5% in January, down from 2.6% in December, marking the first decline in four months.
  
• This trend contrasts with the Consumer Price Index (CPI), which showed an unexpected rise in inflation for the same period.
  

According to the latest data from the Bureau of Economic Analysis, inflation as measured by PCE increased by 2.5% over the past year through January, slightly lower than December’s 2.6%. This marks the first month in four months that this key inflation metric has declined, suggesting inflationary pressures may be easing. Interestingly, this finding diverges from the Consumer Price Index report released earlier, which showed a surprising acceleration in inflation during January.

The downward shift in PCE inflation offers hope that inflation is gradually moving toward the Federal Reserve’s target rate of 2%, a level typical before the pandemic. While inflation had been trending downwards after the pandemic-induced spike, progress stalled in recent months.

This encouraging inflation report aligns with economists’ expectations and could alleviate concerns among consumers and investors about persistent inflation that might prevent the Fed from lowering interest rates.

Core PCE inflation, which excludes the often-volatile food and energy sectors, fell to 2.6% year-over-year in January, down from a revised 2.9% in December — its lowest level since June. Policymakers prefer this core measure as it better reflects underlying inflation trends unaffected by short-term price swings.

The CPI and PCE inflation metrics differ in calculation methods and price coverage; for example, CPI is more sensitive to housing cost changes. Though they typically move in tandem, occasional divergences occur. The Federal Reserve prioritizes the PCE measure, especially core PCE, when evaluating whether inflation aligns with its 2% goal. Some analysts suggest the CPI’s unexpected January rise may be due to data anomalies.

Trade Tariffs: An Uncertain Factor for Inflation

Most forecasts anticipate inflation to gradually decline throughout the year, offering some relief to households burdened by rising everyday costs. However, upcoming tariffs proposed by former President Donald Trump, set to take effect soon, introduce significant uncertainty and could elevate prices across various goods.

Despite the January dip in inflation, this alone may not be sufficient to prompt the Federal Reserve to cut interest rates in the near term. The Fed has maintained higher benchmark rates to restrain borrowing, slow economic activity, and reduce inflation. Officials have indicated they will await clearer signs of sustained inflation decline before easing monetary policy, especially considering the potential inflationary impact of trade tensions.

"The Federal Open Market Committee is unlikely to lower rates until core PCE inflation shows a clear downward trend," explains Gus Faucher, chief economist at PNC. "While a rate cut is anticipated in May, it could be delayed into 2025 or even 2026 if tariffs and wage growth drive inflation higher in the near term."

Update as of Feb. 28, 2025: This article includes new analysis from economists and discusses implications for Federal Reserve policy.

Correction as of Feb. 28, 2025: December core PCE inflation data was revised based on updated BEA figures.

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