US inflation comes in below expectations in August amid high energy prices linked to Iran war

US inflation rose less than economists had expected in August, while price pressures in July were also revised lower. The softer data could reportedly ease pressure on the Federal Reserve to consider another interest-rate hike in October.

However, another rate increase later this year has not been ruled out, as a Commerce Department report showed consumer spending jumped in August. The US economy has so far remained resilient despite pressures linked to the US-Israel war with Iran, which has pushed up energy prices. Economists had expected inflation to stay elevated amid record-high diesel prices.

Following the inflation data, financial markets reduced their expectations for another Fed rate hike next month.

"The less-than-feared price data for August may buy the Fed time to await more data and pass on October 28, but still-elevated inflation and a resilient consumer and economy point to another rate hike by year-end," said Sal Guatieri, a senior economist at BMO Capital Markets.

The Personal Consumption Expenditures Price Index rose 0.3% last month after a downwardly revised 0.1% gain in July, the Commerce Department's Bureau of Economic Analysis said. Economists polled by Reuters had forecast the PCE price index rising 0.4% after a previously reported 0.2% gain in July.

Inflation over the month was driven by a 4.4% rebound in gasoline prices. Food prices were unchanged.

In the 12 months through August, PCE inflation advanced 3.4% after increasing by a downwardly revised 3.4% in July. PCE inflation was previously reported to have increased 3.7% in July on a year-on-year basis. The BEA changed its methodology for calculating prices for software and accessories, portfolio management fees and legal services in the PCE price index, accounting for the downgrade to the year-on-year inflation rate.

It also revised the inflation data going back to 2021. Excluding the volatile food and energy components, the PCE price index climbed 0.2% over the month after a downwardly revised 0.1% rise in July. The so-called core PCE inflation was previously estimated to have gained 0.2% in July.

It was last month lifted by a 1.4% jump in the cost of transportation services as well as solid increases in the cost of services at restaurants and bars, and hotel accommodation.

Core PCE inflation increased 3.0% year-on-year in August after a downwardly revised 3.0% advance in July. Underlying inflation was initially estimated to have risen 3.3% in the 12 months through July.

Methodology changes lowered core PCE inflation by about 36 basis points, more than the 20-30 basis points that economists had expected. Portfolio management services accounted for the bulk of the downgrade.

The US central bank tracks the PCE price measures for its 2% inflation target.

"Two months' worth of data is not enough to point to a new trend, especially when the monthly reading for August reaccelerated," said Stephen Stanley, chief US economist at Santander US Capital Markets. “Nevertheless, there is at least some reason to be a little more optimistic. At a minimum, the Fed can afford to be judicious in hiking and may not need to raise rates by very much to steer inflation down toward target.”

Rate Hike expectations dialed back

The Fed this month raised its benchmark overnight interest rate to the 3.75%-4.00% range, the first rate hike in three years, and flagged further increases in borrowing costs in the months ahead. The odds of an October rate hike were diminished by New York Fed President John Williams' comments on Tuesday that he saw "no urgency" for further action.

Financial markets priced in a roughly 41.5% chance of a rate increase at the October 27-28 meeting, down from 51.5% prior to the data and 70% on Monday, CME's FedWatch Tool showed. Stocks on Wall Street were trading higher. The dollar slipped against a basket of currencies. US Treasury yields fell.

Higher inflation and borrowing costs could crimp consumer spending. A survey from the Conference Board on Tuesday showed consumer confidence plummeting to a near 12-1/2-year low in September. There are, however, no signs yet of consumers dialing back. Consumer spending, which accounts for more than two-thirds of economic activity, surged 0.9% last month after a downwardly revised 0.1% gain in July, the BEA said. Spending was previously estimated to have gained 0.2% in July.

After adjusting for inflation, consumer spending increased 0.6%, putting it on course for another strong quarter of growth. Spending had already expanded at a 3.8% annualised pace in the April-June quarter, contributing to the economy’s 2.2% growth during the period. Business investment in AI infrastructure also supported GDP, with spending on equipment recording another quarter of double-digit growth.

Consumer demand has additionally been supported by gains in AI-related stocks, along with households drawing down their savings and putting less money aside for emergencies. Annual data revisions showed that households had accumulated more savings than previously estimated and had higher incomes than earlier calculations indicated, helping explain the continued strength in consumer spending.

Income growth, however, remained modest in August, rising 0.2% and increasing 0.3% after taxes. When adjusted for inflation, disposable income was unchanged. The personal saving rate fell to 4.1% from 4.6% in July, reaching its lowest level since November 2022.

"We remain cautious that as real labor incomes slow with higher gas prices, there remain headwinds to spending in coming months," said Veronica Clark, an economist at Citigroup.

Strong consumer spending could support GDP growth this quarter, but the impact may be offset by a sharp increase in imports as domestic demand remains robust. The Commerce Department's Census Bureau stated the goods trade deficit widened 11.5% to $132.6 billion in August, while imports jumped 5.5% to $336.1 billion. Trade has weighed on GDP growth for three consecutive quarters.

"I look for a substantial trade drag of around 2.5 percentage points for the third quarter but, given the strength of demand growth, I still see real GDP growth in excess of 3%," said John Ryding, chief economic advisor at Brean Capital.