Cooling Core Inflation Boosts Odds of Fed Rate Cut to 87% Amid Diverging Policy Views

Gerik

Summary:

The U.S. core PCE inflation index for September came in lower than forecast, reinforcing expectations of a Fed rate cut in December, with market odds rising to 87.2%, though internal divisions remain within the Federal Reserve....

Core PCE Surprise Deepens Expectations for December Rate Cut

The latest inflation data from the U.S. Department of Commerce, though delayed due to a previous government shutdown, has delivered a pivotal signal to markets. The core Personal Consumption Expenditures (PCE) price index excluding food and energy rose just 0.2% in September and 2.8% year-over-year. The annual figure was 0.1 percentage point lower than expected and down from 2.9% in August.

This modest decline in the Fed's preferred inflation gauge introduces a direct causal mechanism supporting monetary easing. Lower-than-expected inflation provides greater flexibility for the Federal Reserve to cut interest rates without undermining its price stability mandate.

Wall Street Rallies as Rate-Cut Bets Intensify

Markets responded swiftly. According to CME Group's FedWatch tool, the probability of a 25-basis-point rate cut in the upcoming Federal Open Market Committee (FOMC) meeting surged to 87.2%. This sharp increase in expectations from prior levels highlights the strong market interpretation that the inflation trend is softening enough to justify looser monetary policy.

The broader market rally reflects a correlation between anticipated rate cuts and investor risk appetite. Lower borrowing costs not only reduce financial burdens for corporations but also improve equity valuations through discounted cash flow models.

Disinflation Signals Mixed with Economic Resilience

The headline PCE index rose 0.3% month-over-month and 2.8% annually matching expectations but within the breakdown, notable divergences appeared. Goods prices increased 0.5%, partly due to residual tariff effects under former President Donald Trump’s trade policies. Meanwhile, service prices rose more moderately at 0.2%. Energy and food costs rose 1.7% and 0.4%, respectively, highlighting that headline pressures persist in specific categories.

Personal income grew by 0.4%, exceeding forecasts, while personal consumption rose 0.3%, slightly below expectations. This combination suggests that while household earnings remain strong, spending is moderating a condition that could further dampen inflationary momentum in the months ahead.

Divergent Fed Views Complicate Policy Path

Despite strong market conviction, internal divisions persist within the Federal Reserve. One camp favors rate cuts to shield labor market strength and address growing layoff trends, as evidenced by slower hiring and a recent uptick in job separations. However, others remain cautious, emphasizing that core inflation, while improving, has not yet returned convincingly to the 2% target.

This disagreement reflects differing assessments of risk: one group prioritizes the lagging impact of monetary policy on employment, while the other worries about prematurely loosening conditions and reigniting inflationary pressures. These are not merely differences in forecast but in the weight each faction assigns to inflation versus employment trade-offs.

Consumer Sentiment Improves, Inflation Expectations Dip

The University of Michigan’s consumer sentiment index rose to 53.3 in early December, up 4.5% from November and beating expectations. More critically, inflation expectations fell to their lowest levels since January, indicating the public’s perception of inflation is aligning with softer data a key confidence signal for the Fed.

While not causally linked to rate policy, consumer sentiment correlates with forward-looking behavior such as spending and saving, which in turn affect demand-side inflation pressures. The decline in inflation expectations could further support the Fed's easing bias by confirming its credibility in containing price growth.

Market Eyes December Cut, But Fed Caution Remains

Although the September core PCE print arrived late, it is the final inflation input available to the Fed ahead of its December meeting. The combination of easing inflation, solid income growth, and moderating consumer demand presents a compelling case for a rate cut. With the market pricing in an 87% chance of action, expectations are clearly skewed toward easing.

Yet, as internal Fed disagreement and mixed labor data show, the path forward is not guaranteed. The final decision will hinge not just on inflation data, but on how the Fed weighs risks to growth versus risks of reigniting inflation. Either way, the latest figures strengthen the argument that the peak of the rate cycle is behind us and that monetary easing may return sooner than anticipated.

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