PCE inflation hits 3-year high as markets price 82% chance of Fed hike

The Fed's preferred inflation gauge accelerated to a three-year high in May, pushing rate-hike odds above 80 percent for December.

The core Personal Consumption Expenditures index rose to 3.4 percent in May from 3.3 percent in April, the highest since October 2023 and above the 3.3 percent consensus estimate, the Bureau of Economic Analysis said Thursday. Headline PCE climbed to 4.1 percent from 3.8 percent, matching economist projections.

"The broadening of price pressures seen in April continued in May, with both headline and core moving higher," said Joseph Brusuelas, chief economist at RSM. "But the sharp decline in oil prices from their May apex suggests inflation may have peaked, and we could see a negative month-over-month print in June."

Month over month, core inflation accelerated to 0.3 percent from 0.2 percent in April, while headline held at 0.4 percent. The data comes after the Fed's June 17 meeting, where Chair Kevin Warsh held rates at 3.50 percent to 3.75 percent but removed forward guidance that had signaled a bias toward cuts. Nine of 18 Fed officials now pencil in at least one rate hike this year, with six seeing two or more.

CME FedWatch data shows traders pricing an 82.2 percent probability of a rate hike by December, with odds rising steadily from 29.9 percent in July to 64.9 percent in September and 71.6 percent in October. The Fed's own projections see headline PCE ending the year at 3.6 percent and core at 3.3 percent, well above the 2 percent target. The next policy decision is July 29-30.

The inflation picture is already shifting. West Texas Intermediate crude has fallen toward $70 a barrel from its May peak, after President Donald Trump signaled easing tensions with Iran over Strait of Hormuz shipping. The 30-year Treasury yield dropped to 4.85 percent, its lowest since April 15, as lower energy costs eased near-term inflation fears. But the relief may prove temporary. Core inflation is being driven by sticky service-sector costs, tariff-driven goods inflation, and pricing pressures from the AI infrastructure build-out, Brusuelas noted. The Fed's preferred measure of core PCE has now risen for two consecutive months.

The split in the bond market reflects the uncertainty. The policy-sensitive two-year yield holds above 4.2 percent, near a multi-month high, even as the long end of the curve rallies. That divergence suggests investors expect the Fed to hold short-term rates elevated while betting that the energy-driven spike in headline inflation will fade on its own.

The case for a hike rests on a straightforward calculation. With unemployment at 4.3 percent — essentially at the Fed's estimate of its long-run rate of 4.2 percent — the labor market shows no meaningful slack. May payrolls grew by 172,000. Plug current inflation into the Taylor rule, and the prescribed policy rate sits above the current 3.50 percent to 3.75 percent range, suggesting the Fed is, if anything, too easy. The counterargument: an energy shock is a one-time step-up in the level of prices, not a self-sustaining spiral. It lifts year-over-year inflation now because today's prices sit above last year's, but the effect mechanically fades after 12 months — as long as it does not leak into wages and expectations. That logic likely explains the Fed's decision to hold rather than hike, even as the dot plot tilted hawkish.

For now, the message from the Fed is unambiguous: rate cuts are off the table, and the burden of proof has shifted to the data. If the energy spike proves to be the one-time tax it looks like, the inflation that flipped the dot plot should ebb later this year — and the case for a hike could ebb with it.

This article is for informational purposes only and does not constitute investment advice.