A woman shops in a supermarket in Los Angeles, California, U.S. File
| Photo Credit: REUTERS

U.S. monthly inflation was unchanged in May as a modest increase in the cost of services was offset by the largest drop in goods prices in six months, drawing the Federal Reserve closer to start cutting interest rates later this year.

The report from the Commerce Department on Friday also showed consumer spending rose marginally last month.

It raised optimism the U.S. central bank could engineer a much-desired “soft landing” for the economy in which inflation falls without triggering a recession and a sharp rise in unemployment. Traders raised bets for a Fed rate cut in September.

‘Better behaved’

“It helps the argument inflation is looking better-behaved, which may well open the door to interest rate cuts later in the year,” said James Knightley, chief international economist, ING. The flat reading in the personal consumption expenditures (PCE) price index last month followed an unrevised 0.3% gain in April, the Commerce Department’s Bureau of Economic Analysis said.

Goods prices dropped 0.4%, the most since November. There were big declines in prices of recreational goods and vehicles as well as furnishings and durable household equipment. The price of gasoline and other energy goods dropped 3.4%. Clothing and footwear were also cheaper last month.

The cost of services rose 0.2%, lifted by higher prices for housing and utilities as well as healthcare.

A file photo of the U.S. Federal Reserve
| Photo Credit: Reuters

The U.S. Federal Reserve report released on March 1 flagged a range of what it deemed “notable” vulnerabilities in the financial markets while adding the stress that roiled the banking sector a year ago has faded considerably.

The Fed also used the latest release of its periodic Monetary Policy Report to say that officials will not start moving their short-term interest rate target down until they gain greater confidence inflation is truly moving back to the 2% target.

In the report, the central bank noted several ways in which borrowing levels, or leverage, were increasing risks in the financial sector. It also said stock prices were “close to historical highs.”

The Fed said leverage at hedge funds had stabilized at high levels, while life insurers were facing a situation where they were becoming more reliant on non-traditional sources of funding.

Banking system is sound, says Fed

Meanwhile, while banks’ sources of funding remain liquid and stable, funding costs were on the rise, the central bank said. But even with those rising challenges, the Fed report said “the banking system remains sound and resilient” and “acute stress in the banking system has receded since last spring.”

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A year ago, the Fed contended with bank problems of a magnitude that forced it to launch a new liquidity facility, amid surging demand for central bank credit. Much of that borrowing has faded away as a major concern for markets and the central bank, and the Fed will close this month the Bank Term Funding Program stood up to deal with the troubles.

The Fed report said credit remains available for most who want it, while acknowledging borrowing’s high expense: “Interest rates on both credit cards and auto loans remain higher than the levels observed in 2018 at the peak of the previous monetary policy tightening cycle.”

Inflation under watch

On the economy, the Fed reiterated it was committed to getting inflation pressures back to its target and said the rate-setting Federal Open Market Committee “does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2%.”

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Fed forecasts from the close of last year, buttressed by officials’ comments, have all pointed to rate cuts this year amid falling inflation pressures. However economic strength and an uneven path back to 2% have pushed back market expectations of when the easing will start, likely toward the summer.

The Fed’s twice-yearly report to Congress comes ahead of two days of testimony by Fed Chair Jerome Powell set for Wednesday and Thursday next week. Mr. Powell is likely to face a barrage of questions from lawmakers about the Fed’s tight policy stance and expectations for easing it, a sensitive topic in a presidential election year.

The report generally recaps economic developments and actions taken by the Fed in the period since the previous update given to lawmakers. Fed concerns over financial markets’ vulnerabilities had already been noted in the release of meeting minutes for the January FOMC meeting, released last week.

At the Fed’s most recent policy meeting in January, central bank staff briefed policymakers on their assessment of stability within the U.S. financial system, with the minutes saying staff “characterized the system’s financial vulnerabilities as notable.”

A number of congressional Democrats have already been hounding Mr. Powell over high rates, complaining they are exacerbating already-poor housing affordability for low- and middle-income households. Republicans, meanwhile, have been critical of the Fed’s initially slow response to inflation and could chastise Mr. Powell over indications he may lower rates ahead of the November election.

Rate cuts ahead of the presidential elections?

The Fed’s next interest rate-setting meeting is scheduled for March 19-20, and policymakers are widely expected to leave their benchmark policy rate unchanged at 5.25%-5.5%, where it has been since July.

The upcoming meeting will also bring updated forecasts on inflation, employment, growth and interest rates. In December, the Fed pencilled in three rate cuts, and in comments to reporters on Wednesday, New York Fed leader John Williams said that outlook is a “reasonable” place for Fed officials to think about the monetary policy outlook.

However, the timing of action remains in question. After a benign run of inflation data through the second half of 2023 led financial markets initially to position for rate cuts as early as the March meeting, the first set of inflation readings for 2024 has at least temporarily stalled some of that momentum on taming the pace of price increases.

Market pricing now reflects a prevailing view that the first cut will occur in June, although a first cut at the April 30-May 1 meeting is not out of the question.

The World Bank’s chief economist warned Wednesday that interest rate hikes could spell trouble for countries struggling to deal with debt.

The U.S. Federal Reserve, the European Central Banks and others have raised rates and warned that they could remain high longer than expected in order to bring down elevated inflation.

The International Monetary Fund said Tuesday that the world economy remains resilient despite the fallout from Covid, the war in Ukraine and a cost-of-living crisis, but that it was “limping along, not sprinting.”

“In spite of all of these shocks, we have not seen any big economies really get into trouble. But the good news basically ends there,” said World Bank chief economist Indermit Gill.

“The trouble now is that because of the high rates, the high interest rates that you mentioned, growth is slowing down a lot,” he said at a news conference during the IMF-World Bank annual meetings in Marrakesh, Morocco.

Mr. Gill recalled that during another long period of high interest rates, in the 1970s, around 24 economies were left bankrupt.

“We should expect this tightening cycle to also take long,” he said. “We should expect some countries to (get) into trouble.”

World Bank President Ajay Banga said there was “no doubt” that inflation has begun to come down but that rates will stay higher for longer.

“That can be a complicated event in many ways for investments as well as to people who over the years have got used to a low interest rate environment,” Mr. Banga said.