The Federal Reserve's preferred inflation gauge showed a smaller-than-expected increase in August, indicating progress in the central bank's efforts to combat rising prices.

The Personal Consumption Expenditures Price Index (PCE), excluding food and energy, saw a modest 0.1% rise for the month. This was below the anticipated 0.2% gain predicted by economists surveyed by Dow Jones. The Commerce Department reported these figures on Friday. On a 12-month basis, the annual increase for core PCE stood at 3.9%, in line with forecasts.

In addition to the subdued inflation increase, consumer spending increased by 0.4% in current-dollar terms, a significant drop from July's 0.9% increase. In real terms, spending only increased by 0.1%, compared to a 0.6% rise in July.

When including food and energy, the headline PCE increased by 0.4% for the month and 3.5% compared to the previous year. Headline inflation has been gradually rising in recent months, following a peak of 3.2% in June.

While the PCE index is just one of many factors used by the Fed to measure inflation, it holds particular value because it considers changes in consumer behavior, such as substituting lower-priced items for more expensive ones. This provides a more accurate cost-of-living snapshot compared to the more commonly followed Consumer Price Index, which does not account for substitutions.

The core PCE reading marked the first year-over-year figure below 4% in nearly two years, down from July's 4.3%.

Quincy Krosby, Chief Global Strategist at LPL Financial, commented, "The Fed must be pleased with the overall direction of the PCE report, but declaring victory on quelling inflation would be premature."

Inflation for the month was primarily driven by a 6.1% increase in energy costs, according to the latest data. Food prices also saw a modest 0.2% increase. On an annual basis, energy costs were down by 3.6%, while food prices increased by 3.1%.

The Fed's target for inflation is 2%, indicating a healthy growth rate for the economy. The core PCE last reached this level in February 2021.

The central bank has been steadily increasing interest rates since March 2022, although it chose to hold off on rate hikes at the September meeting to assess the impact of the 5.25 percentage points raised previously. Market expectations suggest that the Fed may have completed its rate hikes, although officials from the recent meeting hinted at the possibility of one more quarter-point increase before the end of the year.

Following the meeting, several Fed officials have indicated that they expect interest rates to remain elevated for an extended period.

However, market-based probabilities for future rate hikes have decreased following this report. Traders now assign only a 15% probability for a rate increase in November, down from 27.5% a week ago, according to CME Group's tracker of fed funds futures market pricing. Odds for a December increase also fell to about 31%, compared to more than 42% a week ago.