A year after inflation soared to the highest level in four decades, price increases are returning closer to normal levels, with families and businesses feeling the difference as wages rise faster than prices and policymakers debate how much more to slow the economy.

Government data released Wednesday showed a notable drop in inflation: Prices rose 3% in June compared with the year before, and 0.2% compared with May, the smallest 12-month increase since March 2021. That marked progress from the last inflation report, when prices rose 4% compared with the previous year.

There is a way to go, especially in major categories such as rent. But encouraging signs were scattered throughout the Bureau of Labor Statistics report. Goods prices, from used cars to meats, saw declines compared to the month before. Categories that bulged over the past year, such as airfares and hotels, are also cooling off as demand settles back to normal.

Meanwhile, wages have grown faster than inflation for four straight months. Average hourly earnings rose 0.4% from May to June, outpacing inflation by 0.2%, according to a separate BLS report released Wednesday.

“This is the kind of mix you want to see, and want to see more of over the next few months. If it does, the pathway to 2% [inflation] for the Fed does open up,” said Skanda Amarnath, executive director of Employ America, a liberal think tank pushing for the economy to run hot.

Major stock indexes flashed green on the news. The Dow Jones Industrial Average climbed 235 points, or 0.69%, at the open. The S&P 500 index rose 0.88%, and the Nasdaq 1.14%.

As has been the case for months, housing costs continue to be the main driver of inflation. Rising rents and other shelter costs accounted for more than 70% of the June increase. Rent is up 8.3% compared to last year, and 0.5% compared to May. There are signs that rents on new leases are finally falling from their pandemic highs, but it will be months before that progress shows up in the consumer price index, which lags behind real-time indicators.

Policymakers are especially fixated on a narrower measure of inflation known as “core inflation,” which strips out more volatile categories such as food and energy and can be especially hard to root out of the economy. That figure rose 0.2% in June compared to May, the smallest one-month increase in that index since August 2021, and a hopeful sign that policymakers won’t have to be even more aggressive in fighting sticky price increases.

The latest data reflects a drastically different economic picture than June 2022, when inflation soared to 9.1%, just months after Russia’s invasion of Ukraine sent energy prices soaring. Part of the reason that this June’s inflation figure dropped so much is that the yearly data compares against last year’s peak. The energy index, for example, which drove inflation for much of last summer, is now down 16.7% for the 12 months ending June.

Car insurance (1.7%), driven by high auto values and costs of repairs, and apparel (0.3%) rose compared to May’s prices. But there were a few bright spots: Airfares (8.1%), used cars and trucks (0.5%), and household furnishings and operations (0.1%) decreased compared to May.

Still, policymakers at the Federal Reserve aren’t ready to declare victory yet, especially since not every source of inflation is fading at the same time or with the same momentum. The Fed typically focuses most on a different inflation measure, but officials also pay attention to the BLS data.

Douglas Holtz-Eakin, president of the conservative American Action Forum, called the report a “classic mixed bag,” and noted that while “we keep waiting for lower market rents to feed in, it hasn’t happened yet.” (Rents and housing costs make up about a third of the basket of goods used to calculate the consumer price index, and it will be difficult for overall inflation to return to normal levels if rent doesn’t cool off.)

The data could mislead policymakers if they put too much stock in energy price drops, Holtz-Eakin warned. Those costs feed into all kinds of goods and services – from transportation to hospitality. If energy costs were to rise again, the shift would lift prices on countless other categories as well.

“I think the Fed should remain vigilant,” Holtz-Eakin said, adding that the new inflation figures should cement two more rate hikes from the Fed, as the central bank is projecting by the end of the year.

The Biden administration, which has faced an uphill battle convincing Americans that it’s got a handle on inflation, cheered the latest progress. In recent weeks, the president has touted his “Bidenomics” plan as a way to rebuild the economy for the middle class. In a statement Wednesday, Biden said the new report showed “Bidenomics in action.”

“The economy is defying predictions that inflation would not fall absent significant job destruction,” Lael Brainard, director of the National Economic Council, said in prepared remarks to be delivered Wednesday afternoon at the Economic Club of New York.

The latest report, she added, offers “new and encouraging evidence that the U.S. economy is on the path to moderate inflation accompanied by a resilient jobs market.”

Annual inflation has fallen for 12 straight months, and the United States now has the lowest inflation readings among so-called G-7 nations.

Overall, inflation continues to move in the right direction without triggering unwanted consequences elsewhere in the economy. Typically, when the Federal Reserve has had to quickly raise interest rates, a recession follows and the job market suffers. That hasn’t happened.

Instead, major banks are backing away from their bold recession predictions as the job market notches its 30th consecutive month of growth. The housing market, too, is showing signs of improvement as more homes come online. Rents are finally starting to drop from pandemic highs, though they remain a major driver of overall inflation. Used car prices are also expected to ease.

If those trends continue, it would mean the Federal Reserve has managed to hoist interest rates by more than 5% points without grinding the economy to a halt. At its most recent meeting in June, the Fed held rates steady for the first time in more than a year to give officials time to gather data on inflation, economic growth, jobs, and wages. Rate hikes affect the economy with imprecise and unknown lags, and the risk is that any additional increases – the central bank is projecting two by the end of the year – will pile onto the braking effect that’s still coming. The repercussions of the spring banking crisis, too, are expected to slow the economy as banks pull back on lending, but no one knows how much.

“The data have come in [with] surprising strength, with inflation persistently printing too high,” San Francisco Fed President Mary Daly said at the Brookings Institution on Monday. “So against that backdrop, you think, ‘Well, there’s more that we need to do.’ ”

But Daly added, “We also had the banking stresses in March, and those banking stresses can act as a credit shock. … So we’re balancing the risks to the economy going forward against the incoming information, which is about strength.”

Policymakers pay close attention to how families and businesses respond or adapt to inflation. Price jumps can come from supply chain backlogs, worker shortages, or energy price spikes. But they can also result from a psychological phenomenon: If people change their behavior now to account for inflation they fear is coming, trying to raise prices or buy up items ahead of the curve, that could make the Fed’s fight to stabilize the economy even harder.

In Durham, N.C., Scott Pearce has had to raise prices across the board at his business, For Garden’s Sake, because costs for machinery, supplies, and hourly pay for entry-level lawnmowers have climbed. Pearce saw demand for his garden supply, landscaping, and lawn maintenance services explode during the pandemic, as stuck-at-home customers decided to revamp their entire properties. That frenzied phase is over, and in the “new normal,” he’s more likely to hear from customers who spend money on their patios now but wait to tackle shrubs a few months down the line.

But Pearce is growing his company even in the face of so much uncertainty. He just filled a new sales role and got a truck delivered to expand fertilization services.

“I don’t want to be irresponsible,” Pearce said. “We could sit and be scared, but part of it is, in our area, people are still spending … These are things they’re probably going to do no matter what. That’s how we’re handling it.”

Richard Farino’s outlook is grimmer. The owner of District Angling, a fly-fishing shop in Arlington, Va., said he hasn’t seen this kind of drop in customer activity since the Great Recession. He pointed to waning consumer confidence in the economy that leads people to spend less on activities and hobbies.

Farino is still contending with supply chain issues for the basics, like the hairs and feathers needed to make and sell flies. He feels pressure to raise prices as manufacturers increase their costs, and worries about how much longer he can stay afloat.

“We are not a store for needs. We’re a store for wants,” Farino said. “And when people start feeling the pinch, they stop doing recreational stuff.”

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