The Fed’s Favorite Inflation Reading Spells Bad News For Interest Rate Cuts

The Federal Reserve’s preferred measure of inflation rose in April to an annual rate of 3.8%, according to a report from the Commerce Department published on Thursday. 

For the past three months, inflation has risen from 2.8% in February to 3.5% in March, and up to 3.8% in April. 

Part of the Federal Reserve’s mandate is to keep Personal Consumption Expenditures inflation, or PCE inflation, at 2%, meaning April’s reading is nearly two points over target and will likely delay the central bank’s ability to cut rates. Bad PCE data typically leads to the Fed keeping interest rates high, which means it can become more expensive to buy a house, finance a car, or take out a personal loan. Businesses also face higher borrowing costs, causing them to raise the prices that consumers pay for goods and services.

“With headline inflation closer to 4% than 3%, the Fed continues to walk a tight rope. When adjusted for inflation, spending barely rose in this report,” said Ellen Zentner, chief economic strategist for Morgan Stanley Wealth Management. “Rising prices are really taking a bite out of consumption, and the decline in the savings rate shows consumers are dipping into savings to make ends meet.”

The personal savings rate dropped to 2.6% after reaching 3.6% in March. 

Core PCE, which excludes food and energy prices, rose to 3.3%. The Fed closely watches core PCE because removing more volatile food and energy categories provides a clearer picture of underlying inflation trends. Core PCE is now at its highest level since the end of 2023.

Despite elevated inflation, PIMCO economist Tiffany Wilding believes headline inflation could fall significantly if tensions in the Middle East ease.

“Inflation right now … looks like a temporary phenomenon. … History suggests that over time oil prices do mean revert and if you get any sort of decline, any mean reversion, or any sort of deal or moderation in tensions in the Middle East in the back half of this year, you could very well see headline inflation then declining … even possibly below 2% next year on the year over year basis,” Wilding said. 

Both CPI and PCE inflation reports have remained above the Federal Reserve’s 2% inflation target for the past five years. The inflation report will make it difficult for the central bank to cut interest rates next month, especially when coupled with Thursday’s downward revision of first-quarter GDP growth from 2% to 1.6% on Thursday. 

Many economists had expected Q1 GDP to stay at 2%. The report from the Commerce Department said the downward GDP revision was due partly to a lower estimate for inventory investment and lower consumer spending.