U.S. PCE inflation holds at 3.7%, markets lift odds of a Fed hike

U.S. inflation showed little progress in July, reinforcing expectations that the Federal Reserve may need to tighten policy again. Data released Wednesday by the Department of Commerce showed the personal consumption expenditures (PCE) price index rose 3.7% from a year earlier in July, unchanged from June. It was the 65th straight month inflation has run above the Fed's 2% goal. The details came in hotter than forecasts. Economists polled by Reuters had looked for 3.6% year-over-year. The monthly gain was 0.2% versus expectations for 0.1%, after a 0.1% decline in June that had marked the weakest reading since April 2020. Core PCE, which excludes food and energy, increased 3.3% year-over-year, also unchanged from June. On a monthly basis it accelerated to 0.2% from 0.1%. Rate expectations adjusted quickly. After the release, federal funds futures showed the implied probability of a September rate hike rising from about 36% to around 44%, with traders fully pricing at least one increase before year-end. Omair Sharif, founder of Inflation Insights, called it plainly: "This is data that supports rate hikes." Heather Long, chief economist at Navy Federal Credit Union, said the numbers buy the Fed time but still underscore an unresolved inflation problem, adding the chair needs to be clearer about what he is watching and what conditions would trigger higher rates. Markets moved in tandem. The U.S. dollar posted its biggest gain in nearly four weeks, recouping roughly half of last week's slide that followed Treasury Secretary Bessent's bond-market intervention. The Bloomberg Dollar Spot Index climbed as much as 0.3%. The yen weakened 0.2% to 159.45. The path to today's renewed hike debate reflects a series of shocks. PCE peaked at 7.2% in June 2022, and the sharpest tightening cycle since the 1980s pushed inflation back toward target. Last year, that progress was interrupted when a fresh round of import tariffs after Trump's return to the White House lifted prices across a broad range of goods. Then, at the end of February, the United States and Israel launched attacks on Iran. Before the conflict, PCE stood at 2.9%. The fighting shut down about one-fifth of global oil supply, driving energy costs higher and pushing PCE to a three-year high of 4.1% in May. Six months on, the conflict remains unresolved but fighting has eased; oil prices and the inflation impulse have retreated from spring peaks. Inflation has fallen back to 3.7% and stalled there. New tariff pressures are also emerging. Negotiations with Canada, the United States' second-largest trading partner, broke down last Friday. New tariffs on $20 billion of Canadian goods are already in force, and both sides have announced additional retaliatory steps scheduled to take effect over coming months. The report offers arguments for both camps at the Fed. Those favoring patience note inflation did not re-accelerate; higher oil prices have had limited spillover beyond a handful of categories such as airfares; and beginning next month the Bureau of Economic Analysis will change how it calculates prices for certain services (portfolio management services, software, and computer accessories), a shift that is likely to lower measured inflation. Hawkish voices focus on the upside surprises in both headline and core readings, firmer services inflation excluding housing (a metric some officials cite as a gauge of underlying pressure), diesel prices nearing record highs with broader knock-on effects, the AI boom lifting chip prices, and the renewed trade dispute with Canada. The deeper issue is longer-running credibility: inflation has been above target for more than five years. Some argue the central bank must act decisively or risk losing public confidence. At the same time, the economy is cooling, a point the data may not fully reflect in headline inflation. After two strong months, inflation-adjusted consumer spending was flat in July. Nominal personal income rose 0.4% and consumer spending increased 0.2%, both above expectations, but real growth slipped to zero. Real income is also under strain. Adjusted for inflation, income was up just 0.2% from a year earlier after several months of negative readings, underscoring how cumulative price gains over five years have eroded purchasing power. That backdrop helps explain persistent pessimism in consumer confidence surveys. Growth data painted a mixed picture. Second-quarter GDP expanded at a 1.5% annual rate, in line with last month's initial estimate and down from 2.1% in the first quarter. Beneath the surface, consumer spending—more than two-thirds of U.S. activity—rose at a 3.4% annual rate, revised up from 3.2% and far above the first quarter's 0.5%. Business investment excluding housing jumped 8.5%, reflecting strong demand for AI-related spending. A key gauge of underlying momentum, final sales to private domestic purchasers, grew 4.2%, the fastest pace in more than three years and revised up from 3.9%. It was 1.7% in the first quarter. Housing investment increased as well, the first rise since the end of 2024. What pulled overall GDP down was imports. Imports surged at a 12.5% annualized rate in the second quarter, with a sizable share tied to computer chips and related products used for AI investment. Because GDP counts domestic production, imports are subtracted; that alone shaved 1.64 percentage points from growth. Government spending fell 1%, and a drop in nondefense outlays also weighed on activity. The second-quarter GDP report will receive a third and final revision on September 30. Attention now shifts to Jackson Hole on Friday, where Federal Reserve Chair Kevin Warsh will give his first major address since taking office. He has pledged to end above-target inflation but has not said whether he believes it can fade without additional hikes. Wednesday's release offered little support for that view. The policy rate has been held at 3.5% to 3.75% since December. At the July meeting, three officials dissented in favor of a 25-basis-point increase. Bank of America FX strategist Alex Cohen said Warsh's Jackson Hole remarks carry "clear two-way risks" and remain an important unknown. Politics looms in the background. With just 10 weeks until the midterm elections, gasoline prices remain elevated due to the Iran war, the White House is threatening additional tariffs on Canada and China, and AI infrastructure spending has pushed up prices for computers, gaming consoles, and semiconductors. Cost of living is increasingly central to the campaign.