- In April, the U.S. PCE price index rose by 3.8% year-on-year, marking the largest increase since May 2023, primarily driven by a surge in energy prices due to geopolitical tensions between the U.S. and Iran.
- The core PCE price index slightly increased to 3.3% year-on-year, indicating that geopolitical shocks are impacting core inflation, reinforcing the persistence of price pressures.
- Financial markets have fully priced in that the Federal Reserve will maintain the interest rate range of 3.50%-3.75% until 2027. Last week's meeting minutes showed an increasing openness among policymakers to rate hikes.
Data released by the U.S. Department of Commerce's Bureau of Economic Analysis on Thursday shows that geopolitical factors are becoming the dominant variable in the U.S. inflation trajectory. The April Personal Consumption Expenditures (PCE) price index rose by 0.4% month-on-month, slowing from March's 0.7%, but the sharp year-on-year increase reflects the immediate impact of rising energy costs. Economists surveyed by Refinitiv had accurately predicted the 3.8% year-on-year increase. As the Federal Reserve's preferred inflation measure, the renewed rise in PCE data has completely shattered the already fragile market expectations for rate cuts.
Energy Shock and Core Inflation Stickiness
The data shows that while food and energy components remain volatile, the core PCE price index, excluding these factors, rose by 3.3% year-on-year in April, slightly higher than March's 3.2%. This slight increase in core inflation is particularly concerning for regulators, as it suggests that the secondary effects of energy costs may be seeping into broader goods and services through logistics and production costs. Month-on-month, core PCE rose by 0.2%, slightly down from March's 0.3%, but not enough to change the narrative that overall inflation remains high. Federal Reserve policymakers currently face a dual challenge: addressing imported inflation caused by geopolitical tensions while preventing secondary inflation expectations from becoming entrenched in the real economy.
Interest Rate Expectations Pushed Further Out
Driven by this inflation data, financial markets have undergone significant changes in pricing the Federal Reserve's monetary policy path. Swap positions indicate that the market now expects the Federal Reserve to maintain the benchmark overnight interest rate range at a historically high 3.50%-3.75%, potentially until 2027. This expectation not only shatters any lingering hopes for rate cuts in 2025 or 2026 but also pushes the "Higher for Longer" policy paradigm to the extreme. The minutes from the April 28-29 Federal Open Market Committee (FOMC) meeting released last week hinted that more policymakers are beginning to accept the possibility of further rate hikes if inflation does not recede. Today's data undoubtedly provides substantial support for this hawkish stance.
Concerns Over Consumer Spending Momentum
Despite the sharp rise in prices, consumer spending in April still recorded a 0.5% increase, but this is mainly seen as an increase in nominal spending rather than an expansion of actual consumption. In contrast, March's spending growth was revised to 1.0%. The report noted that substantial tax refunds provided a temporary buffer for consumers, especially low-income families, who continue to draw on savings to maintain spending levels. However, analysts generally believe that as inflation's year-on-year growth outpaces wage increases, coupled with the end of temporary cash flow from tax season, consumer spending may significantly decline in the coming months. Faced with the high uncertainty brought by war, economists expect consumers will eventually start rebuilding savings, which will suppress the consumption momentum that accounts for more than two-thirds of U.S. economic activity. If the geopolitical crisis persists, the U.S. economy may enter a stagflation-like scenario of low growth and high inflation.
