What happened
The core personal consumption expenditures price index rose 0.2 percent in July and 3.3 percent over the previous twelve months, in line with what economists had forecast. Core PCE strips out food and energy, which bounce around for reasons that have little to do with the underlying strength of the economy, and it is the specific measure the Federal Reserve targets when it says it wants two percent inflation.
Alongside the price data came a weaker signal. Real consumer spending, meaning spending adjusted for inflation, was essentially flat. American households, who have carried the world economy through several difficult years, appear to have stopped increasing their purchases in volume terms.
The Federal Reserve has now left its main policy rate unchanged at a range of 3.50 to 3.75 percent for five consecutive meetings. The committee is not unanimous. Three officials dissented at the August meeting in favour of raising rates, arguing that inflation has been above target for too long to keep waiting.
Attention now turns to the meeting on 15 and 16 September. Market pricing puts roughly a two in three chance on no change, with a meaningful minority betting on an increase rather than a cut. The August inflation figures will not be published until after the committee has voted, so officials will decide on the numbers described here.
Why it matters
The combination on display is the least comfortable one a central bank can face. Inflation that refuses to fall argues for higher interest rates. An economy where consumers have stopped spending argues for lower ones. There is no setting that solves both problems, so whatever the Federal Reserve does, it accepts damage somewhere.
American interest rates matter far outside America. The dollar is the currency in which most global trade and most emerging market debt is priced, and US government bonds are the reference point against which almost every other borrowing cost in the world is set. When American yields rise, British gilt yields tend to follow, and gilt yields determine what banks can afford to charge on fixed rate mortgages.
For British savers and borrowers, that transmission is indirect but real. The Bank of England sets UK policy, but it does not set it in a vacuum. If the Federal Reserve turns more hawkish, sterling tends to weaken against the dollar, which makes imported goods and energy more expensive in pounds, which feeds back into UK inflation.
There is also a labour market dimension. If consumer spending has genuinely stalled, hiring usually slows a few months later. Companies do not cut staff the moment sales soften, but they do stop replacing people who leave. That is the mechanism by which a spending slowdown becomes a jobs slowdown.
Explained simply
Think of the economy as a bath filling up. Inflation is the water level rising too fast. The Federal Reserve can only turn the tap, and right now the level is still climbing while the person in the bath has stopped moving.
Interest rates are the tap. Raise them and borrowing becomes more expensive, so households and companies spend less, so sellers find it harder to push prices up. Cut them and the opposite happens. The tricky part is that the tap takes twelve to eighteen months to have its full effect, so the central bank is always adjusting for conditions it cannot yet see.
Core PCE is how the Fed measures the water level. It is preferred to the more familiar consumer price index because it adjusts for the fact that people substitute when prices change — if beef becomes expensive, shoppers buy chicken, and a good inflation measure should capture that. It also covers spending made on behalf of households, such as employer funded healthcare.
At 3.3 percent, the level is more than a full percentage point above where the Fed wants it. That would normally be a straightforward argument for turning the tap down further. What complicates it is the stalled spending figure, which suggests the previous turns of the tap are finally biting hard.
So the September decision is really a judgement about timing. Tighten now and risk pushing a fragile consumer into retreat. Wait and risk letting above target inflation settle into what people expect, which is the point at which it becomes genuinely difficult to remove.
What it means for you
If you have a UK fixed rate mortgage coming up for renewal in the next year, this data slightly reduces the case for waiting. Fixed rates are priced off swap rates, which move with expectations for both the Bank of England and the Federal Reserve. With a rate cut looking less likely on either side of the Atlantic, the argument for holding out on a tracker in the hope of cheaper fixes has weakened.
For savers, the flip side applies. Easy access accounts paying around 4.0 to 4.5 percent are less likely to be cut quickly if global policy stays on hold. If you have been putting off moving cash out of a high street account paying under 2 percent, the gap on offer is not going to close by itself.
If you hold US equities inside an ISA or a self invested personal pension, expect more volatility around the September meeting than usual. Markets are genuinely split, which means the outcome will move prices in a way a well telegraphed decision would not.
And if you hold dollar denominated investments without hedging, remember the currency is doing part of the work in your returns. A firmer dollar flatters US holdings when converted back into pounds, and a softer one does the reverse, regardless of how the underlying shares perform.
The bigger picture
Central banks have spent four years trying to bring inflation down without triggering a recession. On the whole they have done better than most economists expected in 2022. The last stretch, from roughly three percent to two, has proved the hardest, because the easy disinflation from falling energy and unwinding supply chains is long finished.
What remains is services inflation, which is largely wages, and that responds slowly. It is why several central banks have quietly accepted that returning to target will take longer than first advertised.
Watch the September dot plot, which is the chart showing where each Federal Reserve official expects rates to sit in future years, and watch the monthly payrolls figures. If hiring weakens while core PCE stays near 3.3 percent, the debate shifts from when to cut to whether the two percent target is still achievable on the old timetable.
