PCE inflation seen hitting 4.1%, raising odds of July Fed rate hike

The Federal Reserve's preferred inflation gauge likely rose to 4.1% in May, its highest since 2023, reviving bets the central bank will raise interest rates at its July meeting for the first time this year.

"The pickup has been partly due to tariffs and other one-offs, but the Fed is losing patience after the latest round of supply shocks, while housing disinflation has mostly run its course," Aditya Bhave, U.S. economist at Bank of America Securities, said.

Core PCE, which strips out volatile food and energy costs, is forecast at 3.4%, up from 3.3% in April and the highest since October 2023. Financial markets now price a 34% probability of a quarter-point rate hike in July, according to the CME Group's FedWatch tool. The dollar index rose to 101.52, its highest in a year, while gold slipped near a seven-month low as traders braced for a hawkish outcome.

If the data surprises to the upside, it could trigger a broad sell-off in equities, push bond yields higher and strengthen the dollar further — a scenario that would mark a sharp reversal from earlier this year when markets expected the Fed's next move to be a cut. The last time core PCE exceeded 3.4%, the S&P 500 fell 4.2% over the following two weeks as the Fed signaled rates would stay higher for longer.

Gasoline and the Iran Factor

The headline acceleration largely reflects a surge in gasoline prices during May after the outbreak of the Iran war disrupted shipping through the Strait of Hormuz. Crude oil prices have since retreated toward prewar levels after a peace agreement was signed, and more tankers are now moving through the strait. That relief may prove temporary if the core inflation trend continues to firm.

Durable goods prices rose 3.3% over the 12 months through April, a stark contrast to the pre-pandemic era when they typically fell each year and acted as a deflationary force. "If that trend has truly shifted on a more permanent basis, it would represent a meaningful change in the inflation backdrop," Michael Kramer, an investment advisor at Mott Capital Management, said. "In that scenario, the Fed's current policy stance may not be restrictive enough to return inflation to its target."

What Comes Next

The report lands as new Fed Chair Kevin Warsh has signaled a tougher stance on inflation, warning in recent communications that rate hikes could be on the table if price pressures persist. The fed funds rate has been held at 5.25% to 5.5% since July 2023, following 525 basis points of increases from March 2022. OIS markets now price a 34% probability of a quarter-point hike at the July 28-29 meeting, with the remainder of the probability split between a hold and a larger move.

A cooler-than-expected reading could ease those fears and reignite expectations for a cut later this year. But with core inflation running more than a full percentage point above the Fed's 2% target for 62 consecutive months, the burden of proof has shifted. Any upside surprise Thursday would all but lock in a July hike and reset the rate path for the rest of 2026.

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