Inflation in August eased to its lowest level since February 2021, according to a Labor Department report Wednesday that also showed a key measure higher than expected, setting the stage for an expected quarter-percentage point rate cut by the Federal Reserve.

The consumer price index, a broad measure of the costs of goods and services in the U.S. economy, rose 0.2% over the month, in line with the Dow Jones consensus, the Bureau of Labor Statistics reported.

This brought the 12-month inflation rate to 2.5%, 0.4 percentage points lower than the July level, slightly below the 2.6% estimate and at its lowest level in three and a half years.

However, the core CPI, which excludes volatile food and energy prices, rose 0.3% on the month, slightly above the 0.2% estimate. The 12-month core inflation rate remained at 3.2%, in line with the forecast.

The modest uptick in core CPI keeps the Fed on the defensive against inflation, likely negating the likelihood of a more aggressive interest rate hike when policymakers meet next Tuesday and Wednesday.

“This is not the CPI report the market wanted to see. With core inflation higher than expected, the Fed’s path to a 50 basis point cut has become more complicated,” said Seema Shah, chief global strategist at Principal Asset Management.

Stocks fell following the report, while Treasury yields were mixed. However, the market recovered later in the day, recouping its losses as the major averages turned positive.

In the federal funds futures market, traders put the probability at 85 percent that the Federal Open Market Committee will approve a quarter-percentage point, or 25 basis points, interest rate cut when it concludes its meeting on Sept. 18, according to the CME Group’s FedWatch gauge. A month ago, markets were leaning toward a 50-basis-point cut.

“The figure is certainly not a barrier to policy action next week, but the committee’s hawks will likely seize on today’s CPI report as evidence that the last mile of inflation needs to be managed carefully and cautiously – a formidable reason to opt for a 25 basis point cut,” Shah added.

While the figures showed inflation continued to moderate slowly, housing-related costs remain a problem. The housing component of the CPI, which has a weighting of about a third in the index, rose 0.5%, accounting for about 70% of the core increase. The housing index rose 5.2% year-over-year.

Food prices rose just 0.1%, while energy costs fell 0.8%.

Elsewhere in the report, used vehicle prices fell 1%, health care services declined 0.1% and clothing prices rose 0.3%. Egg prices rose 4.8%.

Real earnings also rose during the month, with average hourly earnings outpacing the monthly CPI increase by 0.2%, the BLS said in a separate statement. On a 12-month basis, inflation-adjusted average hourly earnings rose 1.3%.

But lately the Fed’s attention has been focused on the slowing labor market. Job creation since April has slowed to nearly half of what it was in the previous five months. Central bankers say preventing a broader slowdown is now as important as fighting inflation, which in the summer of 2022 hit its highest level in more than 40 years.

Whatever the Fed decides when it concludes its meeting next Wednesday, markets are already pricing in lower rates. Treasury yields, particularly those on 2- and 10-year notes, are at their lowest levels in more than a year. A recession indicator known as an inverted yield curve has recently inverted, a move that often portends both rate cuts by the Fed and a slowdown in the economy.

Wednesday’s report offered further evidence that inflation is slowing, though it remains above the Fed’s 2% target. Prices remained elevated or rose in some areas.

“Even though inflation has slowed, that doesn’t mean the prices of the things people buy have fallen,” said Lisa Sturtevant, chief economist at Bright MLS. “It just means prices aren’t rising as fast. In fact, American consumers are now paying more than 20% more for goods and services than they were before the pandemic.”

For example, airfares rose 3.9% in August, after falling in the previous five months. Motor vehicle insurance also continued its upward trend, rising 0.6%, bringing the 12-month increase to 16.5%. Hospital and related services costs rose 0.4% and are up 5.8% from last year.

At the same time, lower energy costs have helped to lower inflation figures. Gasoline fell 0.6% in August and 10.3% from a year earlier, part of a 4% drop in the energy index that has included a 12.1% drop in fuel prices.