The Fed's Preferred Inflation Metric Came in Cooler Than Expected. Here's What That Means for Interest Rates This Year

Investors always have at least one eye on interest rates, but after the Fed hiked the Fed funds rate earlier this month, interest rates are back on center stage. At the same time, treasury yields have soared, lifting everything from mortgage rates to credit card APRs, adding to the pressure for investors.

Against that backdrop, investors hoping for some relief from higher interest rates got a gift on Wednesday as the Fed's preferred inflation gauge, the personal consumption expenditure (PCE) Index, came in cooler than expected for August.

Image source: Federal Reserve.

What happened with the PCE

The August PCE rose 3.4% from a year ago, unchanged from July, and represents a downward trend from its peak of 3.8% in May.

What was more important, however, was that August PCE was much lower than expectations at 3.7%, showing that analysts are overestimating the likelihood of future interest rate hikes. Sticky inflation has been the biggest reason for the Fed to raise rates, as new Fed Chair Kevin Warsh has promised to tame inflation, which has been above the Fed's target of 2% for five years.

Core CPE, which excludes the volatile food and energy categories, was 3%, unchanged from June and July but below consensus expectations of 3.3%. In other words, inflation seems to be holding steady, even amid expectations that it has gone higher.

What the PCE reading means for interest rate hikes this year

Markets quickly adjusted to the cool PCE reading as the probability of a 25-basis-point rate hike to 4%-4.25% fell from 51% yesterday to just 37%, according to futures pricing. One week ago, that percentage was 70%, showing expectations for another rate hike have fallen significantly.

Notably, the PCE reading is just one of several points the central bank will consider when it meets for the next Federal Open Market Committee on Oct. 27-28.

On Friday, we'll also get the September employment report, and later in October, the Consumer Price Index (CPI) will come out, which could influence the Fed, as the next PCE report will come out after the Fed meeting.

What it means for investors

Despite the significant adjustment to rate hike forecasts, the S&P 500 (SNPINDEX:^GSPC) was only up modestly on Wednesday, trading up 0.5% in late morning, and it did get a bump when the PCE report first came out.

The Nasdaq Composite was up 0.9% at the same time, but tech stocks may also be getting a lift from yesterday's meeting of the top AI executives at the White House, which ended with an agreement to work together on AI safety, though without any formal regulations.

Today's gains show that the prospect of lower interest rates, or a lack of hikes, will give stocks a boost, but it's only one of several factors influencing the market, and AI remains the most dominant force.

Investors should look out for Friday's unemployment rate and the next CPI report for more signs of whether the Fed will hike, but all else being equal, cooling inflation is a bullish sign for stocks.

Jeremy Bowman has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.