May Inflation Report Set to Challenge Fed's Easing Hopes Amid Iran Tensions

The Federal Reserve's favored inflation indicator, the Personal Consumption Expenditures (PCE) price index, is expected to reveal a notable uptick for May, suggesting the central bank's battle to tame price gains is far from over.

Economists surveyed by Dow Jones Newswires and The Wall Street Journal predict the PCE index climbed 4.1% year-over-year, up from April's 3.8% and marking the steepest rise since last year. This surge primarily reflects a spike in gasoline costs, triggered by the conflict in Iran during the month, although prices began retreating after a peace deal was signed.

More telling to market watchers is the core PCE inflation, which strips out volatile food and energy prices. This metric is forecast to increase 3.4% annually, nudging higher from April's 3.3% - the highest since October 2023. Sustained core inflation above 2% has been a persistent headache for the Fed since 2021.

Core inflation's persistence puts the Fed in a tricky spot. The central bank's main tool-raising the fed funds rate-could see renewed use as officials wrestle with the implications of this stubborn underlying inflation.

As of Wednesday, futures markets estimated just a 34% chance of a quarter-point rate hike in July, based on CME Group's FedWatch. But Thursday's inflation figures could easily tilt those odds, either dampening or fueling expectations.

Adding complexity, the drop in housing inflation, which soared during the pandemic, has been a bright spot, bringing core inflation closer to the Fed's target at times. Yet, recent tariff hikes and supply disruptions from the Iran conflict have reignited inflation fears, complicating the outlook.

Aditya Bhave, an economist at Bank of America Securities, noted that while some of the inflation pressures stem from one-time factors like tariffs, the Fed's patience seems to be wearing thin amid these ongoing supply shocks.

On the energy front, tensions appear to be easing as shipping through the Strait of Hormuz picks up again, pushing crude oil near pre-war prices. However, other categories, like durable goods, are telling a different story. Prices for items meant to last over three years rose 3.3% in April, revealing that inflationary pressures have spread beyond fuel.

This is a departure from historical patterns where durable goods prices typically declined, acting as a deflationary force. Michael Kramer of Mott Capital Management highlighted that if this shift proves lasting, it could signal that current Fed policies aren't tight enough to bring inflation back to target levels.