The Federal Reserve's preferred inflation gauge, the Personal Consumption Expenditures (PCE) price index, rose to 4.1% in May, marking its fastest annual pace in over three years. That's up from April's 3.8% reading and signals that price pressures remain stubbornly high, even as other inflation threats begin to ease.
Core PCE, which strips out volatile food and energy prices, climbed to 3.4% in May, its highest level since October 2023. While the headline number grabbed attention, the core reading is closely watched by economists because it offers a clearer view of underlying inflation trends.
Why the Fed Prefers PCE Over CPI
Most investors are familiar with the Consumer Price Index (CPI), which measures the cost of a fixed basket of goods. But the Fed relies on the PCE for a few key reasons. First, the PCE covers a broader range of items, including services that households buy indirectly, such as medical care paid for by employers or government programs. Second, it adjusts for how consumers actually change their spending habits when prices rise—for example, switching to a cheaper brand of cereal when the usual one gets too expensive. That makes it a more dynamic and accurate measure of real-world inflation.
The May PCE data came in line with expectations, according to reports, but the continued acceleration is a reminder that the Fed's battle against inflation is far from over. The central bank has kept interest rates at elevated levels to cool demand, but persistent price increases could delay any potential rate cuts.
One Inflation Threat Fades, Another Builds
Last month's hot inflation reading was partly driven by a spike in oil prices after the prolonged closure of the Strait of Hormuz, a critical chokepoint for global energy supplies. However, a recent peace deal between the US and Iran has eased those tensions, and crude oil prices have fallen back below their pre-conflict levels. That helped push the FTSE 100 higher and provided some relief to inflation-weary investors.
But just as that geopolitical risk subsides, a new and potentially more disruptive threat is emerging: El Niño. The Pacific Ocean-warming climate pattern is expected to return this year, with some forecasters warning it could develop into a powerful "Super" El Niño. If those predictions hold, the resulting shifts in rainfall and temperatures could slash crop yields, push commodity prices higher, slow economic growth, strain power grids, and snarl global supply chains.
Agricultural commodities like wheat, corn, and soybeans are particularly vulnerable to extreme weather. A severe El Niño could reduce harvests in key producing regions, driving up food prices and adding to inflationary pressures. That would be bad news for central banks trying to bring inflation back to their 2% targets.
What It Means for Investors
For everyday investors, the combination of sticky core inflation and a looming climate risk creates a tricky environment. Higher inflation typically erodes the real value of fixed-income investments like bonds, while it can benefit sectors like energy and commodities. But the uncertainty around El Niño makes it hard to predict which assets will perform best.
Gold, often seen as a hedge against inflation and uncertainty, has been hovering above $4,000 per ounce, rebounding after the PCE data matched forecasts. Meanwhile, Treasury yields edged lower as the inflation reading came in slightly cooler than some had feared, according to reports. That suggests bond markets are still pricing in a potential peak in rates, but the path forward remains uncertain.
Investors should also keep an eye on the Canadian dollar, which bounced back after the PCE data eased pressure on the US dollar. Currency movements can affect the returns of international investments and the cost of imported goods.
The bottom line: while one inflation threat is fading, another is building. The Fed will be watching both the PCE data and the potential impact of El Niño closely. For now, investors should brace for continued volatility and stay diversified across asset classes that can weather both inflation and climate-related disruptions.
