Fed Inflation Gauge PCE Rises to 4.1% Three-Year High

The Federal Reserve faces mounting challenges in controlling rising prices after its preferred inflation measure reached a three-year peak in May. The Personal Consumption Expenditures (PCE) index rose 4.1% annually, marking the highest level since April 2023 and exceeding April’s reading of 3.8%.

The reading matched economists’ forecasts for the PCE report to come in at 4.1% annually, according to financial data service FactSet. On a monthly basis, inflation climbed 0.4% in May, matching April’s increase and down from 0.7% in March. Core PCE, which strips out volatile energy and food prices, rose 3.4% annually, slightly higher than the 3.3% forecast by economists.

The Iran war reignited inflation by driving up oil and gasoline prices, leaving American drivers paying the highest fuel costs in three years. The conflict lifted gas prices to nearly $4.50 a gallon on average nationwide last month, though they have since fallen back to $3.92 as of Thursday, according to AAA. Despite the decline, that’s more than 20% above prices at this time last year as the driving season gets underway.

Energy Costs Drive Latest Inflation Spike

The increase in inflation was largely driven by more expensive gasoline, as well as pricier semiconductors and other computer equipment that are in high demand for the AI buildout. Investors closely monitor these inflation readings because the Federal Reserve uses them to make interest rate decisions. Rising prices have prompted the inflation-fighters at the Federal Reserve to keep their key rate unchanged this year, a reversal from January when they had penciled in two cuts.

Oil prices have plunged close to their levels when the Iran war started in February, with Brent crude, the international benchmark, dipping 34 cents, or 0.5%, to $73.40 a barrel on Thursday. This represents a decline of more than 35% from its most recent peak of about $114 a barrel, according to FactSet. The drop followed the US president’s agreement to a peace deal with Iran, though the status of the Strait of Hormuz remains uncertain.

“It’s our expectation that inflation will start going lower now that the Strait of Hormuz has reopened and oil prices are coming down, so that may alleviate some of the pressure on the Fed, but next month’s data needs to be lower than what we are seeing today if that is going to be the case,” said Chris Zaccarelli, chief investment officer for Northlight Asset Management, in an email.

Peak Inflation May Be Behind Us

May’s PCE report could mark the peak of the latest inflation surge because crude oil prices eased in June amid hopes that the Strait of Hormuz, the key Persian Gulf waterway that handles 20% of global oil flows, could soon reopen. That drop in energy costs isn’t reflected in the latest PCE data, analysts noted. The expectation among economists is that headline inflation has peaked and will trend lower in the second half of the year, assuming the Strait of Hormuz remains open.

“We estimate headline inflation has peaked and will trend lower in the second half of the year, assuming the Strait of Hormuz remains open,” Nationwide chief economist Kathy Bostjancic said in an email.

In its “dot plot” forecast earlier this month, the Fed said it now expects one rate hike this year, up from a forecast in March of one rate cut. It also said that it expected PCE inflation to end the year at 3.3%. Some economists now forecast the central bank could lift rates this year instead of cutting them.

Consumer Spending Remains Resilient

Despite the jump in prices last month, the latest inflation data shows consumers continued to spend strongly in May, economists noted. Adjusted for inflation, spending rose 0.3% from April to May. Inflation-adjusted incomes rose for the first time in four months, picking up 0.3%, which could bolster consumer spending in the coming months.

Real personal spending is rising at a pace consistent with the trend growth rate of GDP, a positive sign for the economy. Rising real incomes signal that households remain financially capable of maintaining their spending habits. The continued consumer outlays suggest elevated price levels have not yet significantly damaged household budgets. This spending strength could provide the economy with momentum even as inflation remains above the Federal Reserve’s target.

Political and Market Implications

Consumer prices rising 4.1% in May from a year earlier could pose political problems for Donald Trump and his political party as midterm elections near. Inflation has been above the Fed’s 2% target for more than five years, leaving many Americans more gloomy about the future. The inflation rate has clearly inflected since the war in Iran began, though core inflation has grown less slowly since it excludes energy prices.

Investors shrugged off the numbers as the S&P 500 was near flat around noon Thursday. The market seemed focused instead on the impact of the memory shortage after Micron delivered another blowout earnings report. Apple stock was down after announcing price hikes to pass on higher memory and storage costs.

Uncertainty Clouds Economic Outlook

Right now, there’s a lot of uncertainty in both inflation and where interest rates are headed. Oil prices, which have been the primary driver of inflation, have started to come down since President Trump announced an end to the war earlier this month. However, the status of the Strait of Hormuz remains uncertain, creating volatility in energy markets. Brent crude prices are now at their lowest since the war broke out, but analysts caution that geopolitical risks could quickly reverse these gains.

Thursday’s report covers the personal consumption expenditures (PCE) price index, a lesser-known measure compared to the consumer price index, which was released earlier this month and showed a similarly large increase. The Fed prefers the PCE index because it captures a broader range of consumer spending patterns and adjusts more quickly to changes in consumer behavior. The central bank’s determination to drive inflation back to its 2% target remains firm, though the path to achieving that goal has become more uncertain.