Fed's Inflation Gauge Reverses 25-Year Trend to Quash Rate Cut Hopes

An unusual divergence in the Federal Reserve's preferred inflation gauge is forcing investors to recalibrate interest rate expectations for the remainder of the year.

The Fed's preferred inflation measure, the personal consumption expenditures index, is now running hotter than the consumer price index for the first time in 25 years, a reversal that complicates the path for interest-rate cuts and pushes back on the market's easing expectations.

"Over the past 1½ years, housing inflation has slowed by around two percentage points, driving around 0.3 percentage points in PCE inflation reduction but a larger 0.6 percentage point [change] in CPI inflation reduction,” says Preston Caldwell, senior U.S. economist at Morningstar.

Since November, the PCE index has consistently registered between 10 and 40 basis points higher than the CPI. This is a stark reversal of the historical trend, where PCE typically ran 40 basis points below CPI on average. The Cleveland Fed’s Center for Inflation Research is projecting month-over-month PCE to increase 0.58% in March.

With the Federal Reserve's next policy decision looming and a potential leadership change with Kevin Warsh nominated for chair, this persistent PCE heat makes a near-term rate cut increasingly unlikely. Markets are now pricing in less than one 25-basis-point cut by December, according to LSEG data, a significant shift from the multiple cuts anticipated before the inflation picture grew more complex.

A Tale of Two Indexes

The Federal Reserve has long preferred the PCE index for its broader scope, which includes rural households and spending on behalf of consumers, such as employer-provided health insurance. Its monthly weighting updates also capture shifts in consumer behavior more dynamically than the CPI's annual adjustments.

Economists disagree on the primary driver of the recent reversal. While Caldwell points to the heavier weighting of slowing housing inflation in the CPI, Damjan Pfajfar, a vice president at the Federal Reserve Bank of Cleveland, argues that recent shifts in information technology—which is more heavily weighted in PCE—are the primary force. Computer software and accessories, for instance, have seen nearly 12 percent inflation over the past year and make up a larger share of PCE's IT sector.

Global Central Banks on Hold

The Fed is not alone in its cautious stance. The Bank of Japan, European Central Bank, and Bank of England are also widely expected to keep interest rates steady this week, watching nervously for signs of higher energy costs fanning inflation from the war in Iran. This synchronized pause reiterates a global determination by monetary officials to remain vigilant against inflation, a contrast to the more sanguine approach during the 2022 energy shock.

For the Fed, the upcoming meeting could be the last for Jerome Powell as chair, with his term ending May 15. President Donald Trump's pick, Kevin Warsh, is seen as favoring a smaller Fed balance sheet and may end practices like forward guidance and the quarterly dot plot, potentially introducing more volatility to markets.

Stephen Brown, chief North America economist for Capital Economics, wrote in a recent note that most of the factors driving the “unusual situation of core PCE inflation being higher than core CPI inflation should reverse by the turn of the year.” For now, however, the unexpected inflation dynamic is the key variable keeping the Fed on hold and investors on edge.

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