By Lucia Mutikani

WASHINGTON (Reuters) – Underlying U.S. inflation moderated in August, with the annual rise in prices excluding food and energy falling below 4.0% for the first time in more than two years, welcome news for the Federal Reserve as it ponders the monetary policy outlook.

The battle against inflation is, however, far from being won as the report from the Commerce Department on Friday showed overall prices were still elevated, partly due to higher gasoline prices.

While the economy remains strong, consumer spending is slowing, which combined with cooling underlying price pressures raised hopes that the U.S. central bank will not hike interest rates in November. The consumer spending and inflation report is probably the last official economic data release before an expected partial shutdown of the U.S. government due to begin after midnight on Saturday. A lengthy data blackout also could make the Fed reluctant to raise interest rates at its Oct. 31-Nov. 1 meeting.

“This report suggests that there’s progress on inflation,” said Conrad DeQuadros, senior economic advisor at Brean Capital in New York. “I think Fed officials are at the point where they’re shifting the focus to how long do we keep rates at these high levels, rather than how much higher the rates have to go.”

The personal consumption expenditures (PCE) price index, excluding the volatile food and energy components, edged up 0.1% last month. That was the smallest rise since November 2020 and followed a 0.2% advance in July. Economists polled by Reuters had forecast the core PCE price index would climb 0.2%.

In the 12 months through August, the so-called core PCE price index increased 3.9%. It was the first time since June 2021 that the annual core PCE price index was below 4.0%. The core PCE price index rose 4.3% in July.

Slowing underlying inflation was reinforced by two new price measures, the PCE price index excluding food, energy and housing, and PCE services excluding energy and housing, introduced by the government with the August report.

The PCE price index excluding food, energy and housing also gained 0.1% last month after rising 0.2% in July. PCE services excluding energy and housing inflation rose 0.1%. The so-called super core inflation climbed 0.5% in the prior month. Policymakers are watching the super core price measure as they try to gauge progress in their fight against inflation.

The inflation outlook was also bolstered by a survey from the University of Michigan showing consumers’ 12-month inflation expectations fell to 3.2% this month, the lowest since March 2021, from 3.5% in August. Consumers’ long-run inflation expectations slipped to 2.8% from 3.0% last month.

But rising oil prices, which are driving the cost of gasoline at the pump, suggest the road to the Fed’s 2% inflation target will be long.

The overall PCE price index increased 0.4% in August after rising 0.2% in July. In the 12 months through August, the PCE price index advanced 3.5% after gaining 3.4% in July. The central bank tracks the PCE price indexes for monetary policy.

Stocks on Wall Street were trading mixed. The dollar fell against a basket of currencies. U.S. Treasury prices rose, with yields retreating further from multi-year highs.

“Getting (the) year-over-year (core) number below 4% could be a big psychological victory for the bulls and help keep a lid on the 10-year yield,” said David Russell, global head of market strategy at TradeStation. 

CONSUMER SPENDING COOLING

The Fed held interest rates steady last week but stiffened a hawkish monetary policy stance. Since March 2022, it has hiked its policy rate by 525 basis points to the current 5.25%-5.50% range. Financial markets currently expect the central bank will keep rates unchanged at its Oct. 31-Nov. 1 policy meeting, according to CME Group’s FedWatch tool.

Consumer spending, which accounts for more than two-thirds of U.S. economic activity, rose 0.4% last month after surging 0.9% in July. That partly reflected higher sales at services stations because of rising gasoline prices. Spending was also lifted by increased outlays on housing and utilities as well as transportation, hospitals and outpatient services.

When adjusted for inflation, spending edged up 0.1% after shooting up 0.6% in July. Consumer spending is expected to have regained speed in the third quarter after slowing in the April-June period, keeping the economy growing.

Spending was supported by incomes, which rose 0.4% amid a 0.5% increase in wages, thanks to a tight labor market. Households also dipped into savings, with the saving rate slipping to 3.9%, the lowest since last December, from 4.1% in July. Rising gasoline prices, declining savings and the resumption of student loans repayments could crimp spending.

The government shutdown, which will leave hundreds of thousands of federal workers furloughed and cut access to food and nutrition assistance programs for millions of people among the wide range of disrupted services, is seen hurting spending.

“There is no sign of a major pullback in consumer spending that would signal an impending recession in these numbers, but definitely growing signs of stress as consumers increasingly struggle under the weight of rising energy prices and borrowing costs and moderating income growth,” said Scott Anderson, chief U.S. economist at BMO Capital Markets in San Francisco.

Growth prospects for this quarter were boosted by other data from the Commerce Department on Friday showing the goods trade deficit narrowed 7.3% to $84.3 billion in August, with exports rising and imports declining. Retailers also increased inventories. Estimates of gross domestic product growth for the third quarter are as high as a 4.9% annualized rate. The economy grew at a 2.1% pace in the second quarter.

(Reporting by Lucia Mutikani; Editing by Paul Simao)

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