Inflation milestone: Consumer Price Index slows below 3% for first time since March 2021

By Alicia Wallace, CNN

(CNN) — Price hikes slowed more than expected in July, and, for the first time in more than three years, the Consumer Price Index has landed below 3%.

That paves the way for the Federal Reserve to cut rates next month after a yearslong battle with inflation that sent rates spiking to a 23-year high. America’s economy is showing signs of stress, and now that inflation appears under control, the Fed can reduce borrowing costs to try to get job growth booming again.

Consumer prices rose 2.9% for the 12 months ended in July, slowing from June’s 3% annual gain, according to the Bureau of Labor Statistics’ latest CPI report released Wednesday.

On a monthly basis, prices rose 0.2% after posting a 0.1% decline the month before.

Economists were expecting a 0.2% monthly increase and an annual rise of 3%, according to Fact Set consensus estimates.

“Breaking the 3% barrier is a key psychological positive,” Sung Won Sohn, professor of finance and economics at Loyola Marymount University and chief economist of SS Economics, told CNN in an interview. “It shows that inflation is not only trending down, but disinflation is on track.”

Excluding gas and food, categories that tend to be quite volatile, core CPI rose 0.2% from June and saw its annual rate slow to 3.2% from 3.3%. Core CPI inflation is now running at its slowest pace since April 2021.

The cost of owning and renting a home rose 0.4%. That so-called shelter index accounted for nearly 90% of the monthly increase, BLS said in the report.

The S&P 500 closed 0.4% higher on Wednesday as investors parsed the latest inflation report. The Dow rose 242 points, or 0.6%, and the Nasdaq Composite added 0.03%.

Outsized influence of home prices

Shelter, which accounts for more than one-third of the overall CPI, has been the biggest impediment to inflation’s descent. However, economists say, it’s only a matter of time before that hurdle gives.

That’s because the BLS’ measurement of housing-related prices is a very lagged and amorphous process (including estimating the rental value of owner-occupied homes). But in recent months, the shelter index is starting to better reflect the slower, if not flat or falling, rent hikes seen in real life.

Housing costs increased dramatically during the pandemic and the economic rebound that followed driven by heightened demand for remote work that put additional strain on already low inventory. The Fed’s drastic interest rate-hiking campaign further exacerbated the issue by making borrowing costs expensive for renters, buyers and builders alike, Brian Bethune, a Boston College economics professor, told CNN.

“What you’re doing is crossing your fingers that [with the rate hikes] somehow the effect on demand will be larger than the effect on supply for the immediate future,” he said. “Because if the situation persists, then the chronic shortage of housing will just get worse.”

On an annual basis, the shelter index is up 5.1% through July. It has been on a steady decline since peaking at 8.2% in March 2023, BLS data shows.

“If you look at the future, it’s pretty clear that the inflation picture will continue to improve,” Sohn said.

Excluding shelter, the CPI was up 1.7% for the 12 months ended in July, according to BLS data.

Energy prices (notably gasoline), which had served as a drag on the May and June CPI, were flat for July. Food prices continued to rise only modestly, with grocery prices up 0.1% for the month and restaurant prices up just 0.2%.

On an annual basis, grocery and restaurant prices are up 1.1% and 4.1%, respectively.

The goods category saw its long stretch of disinflation (prices rising more slowly) and outright deflation (prices falling) continue during July. Services ticked up 0.3%.

The indexes for used cars and trucks, medical care, airline fares and apparel were among those that decreased from June, the BLS noted in Wednesday’s report.

An ‘unequivocally’ good report that tees up rate cuts

The CPI, which measures the average change in prices for a commonly purchased “basket” of goods and services, has cooled down noticeably since briefly flaring up to start the year.

Wednesday’s report builds on a June report that was solidly positive (the overall index fell for the first time since April 2020) and helped assure the Federal Reserve and markets that inflation is indeed moderating.

The July CPI “was, unequivocally, a good report,” Boston College’s Bethune said.

“If you look at the reported monthly gains — 0.2% overall, 0.2% on the core — that is considered to be perfectly acceptable,” he said. “But if you take a look under the hood, it’s actually even better than that.”

Unrounded, the overall CPI increased just 0.155% from June and core increased 0.165%, BLS data shows.

The central bank has wanted to see more sustained progress in slowing inflation before loosening monetary policy; however, that calculus changed in recent months as the labor market slowed, and unemployment rose more sharply than expected.

A weaker-than-expected jobs report for July, with an estimated 114,000 jobs added and a jump in unemployment to 4.3%, sent markets into a tailspin last week as recession fears picked up steam.

“Any Fed official waiting for a little more data to make the decision on whether to cut interest rates got it in spades this morning as while inflation isn’t dead, there is deflation in commodity prices which balances out the moderate inflation seen in some services prices, which is mainly generated from the higher costs of housing,” Christopher Rupkey, chief economist for FwdBonds LLC, wrote in commentary issued Wednesday.

Also, while the CPI is the most widely used barometer of inflation, the Fed’s preferred gauge for its 2% target is the Personal Consumption Expenditures price index, which slowed to 2.5% in June. And that PCE picture should be looking even more positive when it’s released at the end of the month, said Robert Triest, an economics professor at Northeastern University.

Not only are components of the CPI and Tuesday’s better-than-expected Producer Price Index baked into the PCE gauge, but also shelter carries less of a weight in that index.

“I would expect the PCE numbers to come in even more favorably than the CPI did,” Triest said in an interview. “And that will provide further comfort and further support for the Fed to begin cutting the federal funds rate.”

The Fed is widely expected to cut its benchmark interest rate by at least a quarter-point at its meeting next month, although some projections for a half-point cut grew after the weak jobs report.

As of Wednesday morning, the CME FedWatch tool had a 56.5% probability for a quarter-point cut and a 43.5% probability for a half-point cut.

Jared Bernstein, the chair of the White House Council of Economic Advisers, on Wednesday touted the latest CPI data but also pledged “no victory laps.”

“Our work is not done, because even as we get inflation back down to pre-pandemic levels, we still have to be mindful that too many families are facing too many high costs,” he told reporters during Wednesday’s White House press briefing.

This story has been updated with additional developments and context. As stocks settle after the trading day, levels might change slightly.

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CNN’s Krystal Hur and Donald Judd contributed to this report.