Key Inflation Gauge Jumps to 3-Year High

The Federal Reserve's preferred inflation gauge rose to a new three-year high in May as gas prices peaked. Consumer prices rose 4.1 percent in May from a year earlier, the Department of Commerce said Thursday, the largest annual increase since April 2023. On a monthly basis, inflation was 0.4 percent last month, matching April's increase and down from 0.7 percent in March.

The increase was largely driven by more expensive gas, as well as pricier semiconductors and other computer equipment that are in high demand for the AI buildout. Rising prices have caused the inflation-fighters at the Federal Reserve to keep their key rate unchanged this year, a reversal from January when it had penciled in two cuts. Some economists forecast the central bank could lift rates this year instead.

"Underyling inflation is closer to 3 percent rather than 2 percent," said Mark Vitner, chief economist at Piedmont Crescent Capital. "It does suggest to me that the next Fed move, whenever it comes, is more likely to be a hike than a cut." The Fed probably won't raise rates until next year, he added.

Prices at the pump are falling

Oil and gas prices have fallen substantially since Trump agreed to a peace deal with Iran earlier this month, but the conflict lifted gas prices to nearly $4.50 a gallon on average nationwide in May. They have since fallen back to $3.92 as of Thursday, according to AAA, but that's more than 20 percent above prices at this time last year as the driving season gets underway.

Declining gas prices will likely pull down headline inflation rates next month, yet measures of underlying inflation remain stubbornly elevated and will be a concern for the Fed. Excluding the volatile energy and food categories, core prices rose 3.4 percent in May compared with a year earlier, up from 3.3 percent in April and the largest increase since October 2023. On a monthly basis, they rose 0.3 percent from April to May, the same as the previous month.

Other factors at play

Higher gas prices aren't the only thing worsening inflation. The AI buildout has made computer components more expensive, and Apple announced last week that it would raise prices for its computers and iPads because of the higher costs. Prices for services also rose sharply last month, lifted by more expensive restaurant meals, hotel rooms, auto repairs and health care.

At the same time, consumers appear willing to keep spending and boosting the economy. Adjusted for inflation, spending rose 0.3 percent from April to May. And inflation-adjusted incomes rose for the first time in four months, picking up 0.3 percent, which could bolster consumer spending in coming months.

A separate report Thursday on the PCE Index, which covers the personal consumption expenditures, showed that the economy expanded at a 2.1 percent annual rate in the first three months of the year, an upgrade from a previous estimate of 1.6 percent. And the number of people seeking unemployment benefits fell last week, a sign that layoffs remain low.

Fed's target rate is still 2 percent

New Fed chair Kevin Warsh last week underscored the central bank's determination to drive inflation back to its 2 percent target, but he gave no sign of which steps the Fed might take. Some economists, however, now expect the central bank to increase rates this year. Those expectations upended U.S. markets this week, hammering fast-growing sectors like tech.

Inflation has been above the Fed's 2 percent target for more than five years, leaving many Americans more gloomy about the future. Vitner points out that inflation hadn't topped 2.5 percent for nearly a decade before the pandemic, likely making the inflation spikes since then even harder to accept for most households.

Thursday's PCE Index report is a lesser-known measure compared with the consumer price index, which was released earlier this month and showed a similarly large increase. The Fed prefers to use the PCE index because it puts less weight on housing and also reflects changes in how Americans shop when prices rise, such as when consumers buy cheaper off-brand items.