Federal Reserve officials may see less urgency to raise interest rates in September after a government report showed inflation easing for a second consecutive month in July. At the same time, they may not yet be convinced that monetary policy is sufficiently restrictive to ensure that the slowdown continues.

Inflation data

US consumer prices rose only slightly in July, as gasoline costs fell for a second consecutive month and underlying inflation remained contained, further reducing expectations that the Federal Reserve will raise interest rates next month.

The Labor Department report released on Wednesday showed that the modest increase in the Consumer Price Index in July was in line with economists expectations. Small increases in food and clothing prices were partly offset by declines in hotel and motel rates and prescription drug costs.

The report followed last weeks data showing that the US economy unexpectedly lost jobs in July. It also suggested that the surge in oil prices caused by the conflict in the Middle East has so far had only a limited impact on consumer prices.

However, economists said an interest rate increase later this year remains possible, with inflation still well above the central banks 2% target. Fed officials will receive another round of inflation and employment data for August before their September meeting.

Scott Anderson, chief US economist at BMO Capital Markets, said the report, while not decisive, should ease Fed concerns about the possibility of an energy-driven inflation spiral. However, he added that policymakers would need to see further evidence that underlying services inflation is cooling before completely abandoning the possibility of another rate increase.

The CPI rose 0.1% last month after falling 0.4% in June, its first decline in six years, according to the Labor Departments Bureau of Labor Statistics.

A 0.1% increase in shelter costs accounted for roughly two-thirds of the overall CPI increase. The rise came despite a sharp 3.3% drop in hotel and motel rates, likely linked to the end of the World Cup, which partly offset a 0.3% increase in owners equivalent rent.

Gasoline prices fell 2.9% after declining 9.7% in June.

Food prices rose 0.1% following a 0.2% increase in June. Grocery prices fell 0.1%, with pork prices dropping 1.5%, their largest decline since November 2023.

Ground beef prices fell 1.6%, the sharpest decline since September 2020, after Walmart reduced ground beef prices last month. However, ground beef remains 9% more expensive than a year earlier.

Lettuce prices plunged 16.4%, likely reflecting weaker demand associated with the cyclospora outbreak.

Over the 12 months through July, the CPI rose 3.4%, down from 3.5% in June. The Fed officially targets inflation using the Personal Consumption Expenditures price index rather than the CPI.

Rate hike bets fall as real wages decline

Financial markets were pricing in around a 38% probability of a rate increase at the Feds September 15-16 meeting, down from 48.4% on Tuesday, according to the CME FedWatch tool.

Wall Street stocks rose following the report, while the dollar weakened against a basket of currencies and US Treasury yields declined.

The Fed kept its benchmark overnight interest rate unchanged last month in a range of 3.50% to 3.75%.

Despite the slowdown in inflation, the figures are unlikely to provide much relief for consumers. Inflation-adjusted average hourly earnings fell 0.2% year-on-year in July after remaining flat or declining since April.

Joseph Brusuelas, chief economist at RSM, said the challenge for the Fed will be explaining the data to the public. Investors may welcome slower price increases, while consumers, particularly middle- and lower-income households, could be forced to rely more heavily on credit or reduce spending during the second half of the year as their real disposable incomes come under pressure.

Excluding volatile food and energy components, the core CPI rose 0.2% last month after remaining unchanged in June.

Core inflation was driven partly by a 0.4% increase in healthcare prices and a 2.2% jump in airline fares. Information technology-related goods rose 1.4%, led by a 3.5% increase in prices for computers, accessories and smart home devices.

Apple had raised prices for its iPads and MacBooks in June.

Used car and truck prices also increased, while clothing, furniture and household supplies recorded modest gains, suggesting that the impact of tariffs on prices may be beginning to fade.

However, overall core goods prices increased 0.2% after declining for two consecutive months. Some economists said this could indicate that higher distribution costs are increasingly being passed on to consumers.

The cost of services excluding housing rents also increased 0.2%.

Inflation could accelerate in August

The US being a net oil exporter, combined with releases from oil reserves, has helped cushion the economy from the surge in crude prices caused by the conflict in the Middle East. However, some economists warned that this situation cannot continue indefinitely.

The United States and other countries will eventually need to rebuild oil inventories, potentially keeping crude prices elevated.

Economists expect consumer price growth to accelerate in August following the recent rise in oil prices.

Job growth is also expected to recover as seasonal distortions fade.

Based on the CPI data, economists estimated that the core Personal Consumption Expenditures price index rose 0.2% in July after increasing 0.1% in June. That would leave the annual rate at 3.3%, unchanged from June.

Brittany Jackson, US economist at BNP Paribas Securities, said the firms base case remains for the Federal Open Market Committee to raise interest rates in December, although the risks are tilted toward an earlier increase.

Despite the overall moderation, details of the report showed some signs that inflationary pressures were becoming more widespread. Omair Sharif, founder of Inflation Insights, noted that the sharp decline in hotel prices, which is unlikely to persist, accounted for a significant part of the slowdown in monthly core inflation.

At the same time, more categories of core goods recorded price increases than in June.

Technology product prices also jumped, supported by demand linked to artificial intelligence.

The Fed targets inflation at 2% using the annual change in the PCE price index. Sharif and other analysts estimate that despite the July slowdown in CPI inflation, the Feds preferred core inflation gauge remains on track to run at around 3%.

September decision remains open

In a 9-3 vote last month, Fed officials kept short-term borrowing costs within their target range of 3.50% to 3.75%, where they have remained since December.

Fed Chair Kevin Warsh has offered few signals about what conditions would lead him to support a change in interest rates, prompting investors to pay closer attention to the views of other policymakers on the economic and inflation outlook.

Since last months decision, the three Fed officials who dissented in favour of higher rates, along with two regional Fed presidents who do not vote this year, have argued that another rate increase is necessary because inflation remains too high.

By contrast, New York Fed President John Williams, one of the central banks most influential policymakers, has said he expects inflation to continue declining, allowing the Fed to leave interest rates unchanged.

Olu Sonola, head of US economic research at Fitch Ratings, said the absence of clear forward guidance from the Fed means the September decision will probably remain contested until the last moment. The incoming data could provide enough evidence for both those favouring higher rates and those advocating no change to make their case.

Following Wednesdays inflation report, traders increased bets that the Fed will keep interest rates unchanged at its September 15-16 meeting. Those expectations had already strengthened since last Friday, after data showed that the economy unexpectedly lost jobs during the previous month.

Nevertheless, federal funds futures traded through CME still imply a probability of more than one-third that the Fed will raise rates in September.

Investors also remain convinced that the Fed will ultimately need to raise interest rates before the end of the year to contain inflation, which has remained above the central banks 2% target for more than five years.