Consumer price index falls below 3% for the first time since March 2021

Price increases slowed more than expected in July and the consumer price index was below 3% for the first time in over three years.

That clears the way for the Federal Reserve to cut interest rates next month after years of battling inflation, driving rates to a 23-year high. The American economy is showing signs of stress, and now that inflation appears to be under control, the Fed can cut borrowing costs to try to reignite job growth.

Consumer prices rose 2.9 percent in the 12 months through July, slowing from the 3 percent annual increase in June, according to the Bureau of Labor Statistics' latest consumer price index released Wednesday.

On a monthly basis, prices rose by 0.2%, after falling by 0.1% in the previous month.

According to Fact Set's consensus estimates, economists had expected a monthly increase of 0.2 percent and an annual increase of 3 percent.

“Breaking the 3% mark is an important psychological plus point,” said Sung Won Sohn, professor of finance and economics at Loyola Marymount University and chief economist at SS Economics, in an interview with CNN. “It shows that inflation is not only declining, but that disinflation is on track.”

Excluding gasoline and food, categories that tend to be quite volatile, core CPI rose 0.2% from June and its annual rate slowed to 3.2% from 3.3%. Core CPI inflation is now at its lowest level since April 2021.

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

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

Overly large influence of real estate prices

Housing costs, which account for more than a third of the overall consumer price index, have been the biggest obstacle to the decline in inflation, but economists say it is only a matter of time before that hurdle gives way.

That's because the BLS's measurement of housing-related prices is a very lagged and amorphous process (including estimating the rental value of homes). But in recent months, the housing index has begun to better reflect the slower, if not stagnant or falling, rent increases observed in reality.

Housing costs rose dramatically during the pandemic and the economic recovery that followed was fueled by increased demand for remote work, putting additional pressure on already low inventory. The Fed's drastic rate-hiking campaign further exacerbated the problem by making borrowing costs more expensive for renters, buyers and builders alike, Brian Bethune, an economics professor at Boston College, told CNN.

“They keep their fingers crossed that [with the rate hikes] “The impact on demand will be greater than on supply in the immediate future,” he said. “Because if the situation continues, the chronic housing shortage will only get worse.”

On an annual basis, the lodging index rose 5.1% through July. As BLS data shows, it has been steadily declining since peaking at 8.2% in March 2023.

“Looking ahead, it is quite clear that the inflation situation will continue to improve,” Sohn said.

Excluding housing costs, the consumer price index (CPI) rose 1.7% in the 12 months through July, according to BLS data.

Energy prices (especially gasoline), which weighed on the consumer price index for May and June, remained unchanged in July. Food prices continued to rise only moderately: food prices rose by 0.1 percent in the month and restaurant prices by just 0.2 percent.

On an annual basis, food and restaurant prices rose by 1.1% and 4.1%, respectively.

In the goods sector, the long phase of disinflation (slower price increases) and outright deflation (falling prices) continued in July. The services sector recorded growth of 0.3%.

Among other things, the BLS reported declines from June in its Wednesday report, including indices for used and pre-owned cars, medical care, airfares and clothing.

A “clearly” good report that calls for interest rate cuts

The Consumer Price Index (CPI), which measures the average change in the prices of a frequently purchased basket of goods and services, has cooled noticeably since its brief flare-up at the beginning of the year.

Wednesday's report builds on a June report that was consistently positive (the headline index fell for the first time since April 2020) and helped convince the Federal Reserve and markets that inflation is indeed easing.

The consumer price index for July “was undoubtedly a good report,” said Bethune of Boston College.

“If you look at the monthly gains that are being reported – 0.2% overall, 0.2% in the core – that's perfectly acceptable,” he said. “But if you look behind the scenes, it's even better.”

Unrounded, the headline CPI rose just 0.155 percent since June, and the core CPI rose 0.165 percent, according to BLS data.

The central bank wanted to see more sustainable progress in curbing inflation before easing monetary policy. However, this calculation has changed in recent months as the labor market weakened and unemployment rose more than expected.

A weaker-than-expected July jobs report, which reported an estimated 114,000 new jobs and unemployment rising to 4.3%, sent markets tumbling last week as recession fears grew.

“Any Fed official waiting for a few more data to make a decision on a rate cut got plenty of them this morning, because while inflation is not dead, there is deflation in commodity prices that is offsetting moderate inflation in some services prices, driven primarily by higher housing costs,” wrote Christopher Rupkey, chief economist at FwdBonds LLC, in a commentary published Wednesday.

Although the consumer price index (CPI) is the most widely used inflation barometer, the Fed's preferred indicator for its 2% target is the personal consumption expenditures price index, which eased to 2.5% in June. And that PCE picture should look even more positive when it's released later this month, says Robert Triest, an economics professor at Northeastern University.

The PCE index not only includes components of the consumer price index (CPI) and Tuesday's better-than-expected producer price index, but the housing sector also has a lower weight in this index.

“I would expect the PCE numbers to be even more favorable than the CPI,” Triest said in an interview. “And that will provide further reassurance and support for the Fed to lower the key interest rate.”

The Fed is widely expected to cut its benchmark interest rate by at least a quarter of a percentage point at its meeting next month, although some forecasts increased to a half-percentage point cut following the weak jobs report.

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

Jared Bernstein, chairman of the White House Council on Economic Advisory, praised the latest consumer price index data on Wednesday, but also announced that there would be “no victory laps.”

“Our work is not done yet, because even if we bring inflation back to pre-pandemic levels, we still have to be clear that too many families are facing too high costs,” he told reporters during a White House press conference on Wednesday.

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

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

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