Howard Schneider, Ann Saphir

(Reuters) – Evidence that U.S. inflation has cooled will not sway Federal Reserve policymakers to reduce the half-point rate increases scheduled for upcoming meetings June and July. However, if this trend continues, it may lead to a shift towards smaller rate hikes in September.

The U.S. Commerce Department reported Friday that the price index of personal consumption expenses (PCE) rose 6.3% in April compared to one year ago.

This is more than triple the Fed’s target of 2%.

Graphic: The COVID inflation surge – https://graphics.reuters.com/USA-FED/INFLATION/akvezawxopr/chart.png

Prices are rising but the rate of price rise is slower than in the past month. The April PCE reading was the first decrease in this measure since November 2020.

However, the core PCE index (which strips out energy and food prices to provide a more clearer picture of persistent price pressures) rose 4.9%. It is still far too high to be comfortable with, but it marks a second month of moderation after what might have been a February peak at 5.3%.

This is a good sign for the central bank. It also provides new evidence to show that households continue to spend more despite rising prices. The Friday report revealed that consumer spending increased 0.9% in the last month.

Nationwide Economist Dan Hadden stated in a note that while inflation is still high enough for the Fed at 4%, there has been some movement. As long as inflation continues to stabilize or moderate, “it will likely give the (Fed) more flexibility later this year.”

The Fed has lifted interest rates three-quarters of a percentage point so far this year, and most policymakers expect to deliver a couple more half-a-percentage-point rate hikes, recent public comments and a record of their May meeting show.

This would increase overnight bank-tobank borrowing costs by 1.75% to 2% at the end July. The anticipation of rate increases is already affecting the demand for housing in the market. Prices have shot up, but steep rises in mortgage rates have helped to lower home sales.

This suggests that price rises will slow down in the months ahead, according to Comerica (NYSE)’s Bill Adams. Inflation readings will begin to fall late in this year and early in 2023, according Comerica.

Already at the Fed’s May meeting, “a number” of policymakers thought “monthly data might suggest that overall price pressures may no longer be worsening.”

Fed’s broad goal is to move through the era of price surprises and uncertainty without a recession.

On Friday, Lydia Boussour from Oxford Economics wrote that “Amidst rising pessimism regarding the US consumer’s state”, the report provided some assurance that the economic’s main pillar is still strong in the face historical inflation and rising borrowing cost.”

U.S. equity prices, which fell quickly in recent weeks because investors took stock how Fed’s policy shift might slow the economy’s growth, rose Friday after the inflation data, and there was hope that Fed’s “soft landing” may still be possible.

Futures contract traders tied to Fed’s policy-rate Fed bet that central bank would downshift to quarterly rate increases in September.

The rest of the world must cooperate in order for this to happen.

The impact of the Ukraine war on world commodity prices and the ongoing coronavirus lockdowns in China are two major risks fully beyond the Fed’s control.

Fed policymakers said they also monitor inflation expectations to look for indicators that high levels of inflation may be affecting American business and household psychology. These risks are not, according to recent data.

Graphic: ICE (NYSE:) inflation expectations index ICE inflation expectations index – https://graphics.reuters.com/USA-FED/INFLATION/akvezxjwrpr/chart.png

Fed staff, meanwhile, continue to see headline PCE inflation moderating to 4.3% by the end of the year and to 2.5% by the end of next year as a “historically large” tightening of financial conditions was felt throughout the economy, the Fed meeting minutes this week showed.