The Personal Consumption Expenditures price index — the Federal Reserve's preferred inflation gauge — rose 4.1% year-over-year in May, the Commerce Department reported Wednesday, crossing back above the psychologically significant 4% threshold for the first time since late 2024. Consumer spending, meanwhile, remained robust. The combination is precisely what central bankers did not want to see.

For months, markets have priced in the possibility of rate cuts by year's end, betting that inflation would continue its gradual descent toward the Fed's 2% target. May's data suggests that bet may have been optimistic. Core PCE, which strips out volatile food and energy prices, came in at 3.8% — stubbornly elevated and showing little momentum toward the target.

The spending paradox

What makes this inflation reading particularly vexing is its companion data: consumer spending grew 0.4% month-over-month, suggesting American households are neither tapped out nor particularly concerned about their purchasing power. This resilience, ordinarily a sign of economic health, complicates the Fed's calculus. Higher rates are supposed to cool demand, which should cool prices. Demand has not cooled.

The labor market tells a similar story. Unemployment remains historically low, wage growth continues to outpace pre-pandemic norms, and the much-anticipated wave of layoffs has remained confined to specific sectors — technology, media, and now enterprise software, as Oracle's announcement of 21,000 job cuts demonstrated this week. The broader economy has absorbed these shocks without breaking stride.

Markets recalibrate

Bond traders are adjusting their expectations accordingly. The yield on the 10-year Treasury has climbed in recent sessions, reflecting diminished confidence in near-term rate relief. Some analysts now suggest the Fed may need to raise rates again before it can cut them — a scenario that seemed far-fetched as recently as April.

Equity markets, by contrast, have responded with surprising equanimity. The S&P 500 has held its gains, buoyed in part by strong corporate earnings from semiconductor firms like Micron, whose blowout results Wednesday reminded investors that certain corners of the economy are thriving regardless of monetary policy. The divergence between bond and stock market sentiment is itself a kind of message: nobody knows what comes next.

The credibility question

Chair Jerome Powell has repeatedly emphasized the Fed's commitment to price stability, even at the cost of short-term economic pain. But the central bank has now held rates steady for several meetings, and each month of elevated inflation without action erodes that credibility. The Fed cannot talk inflation down; it can only raise rates or wait.

Waiting has its own costs. If inflation expectations become unanchored — if consumers and businesses begin assuming 4% is the new normal — the Fed's job becomes exponentially harder. The 1970s demonstrated how quickly a credibility deficit can spiral into a decade of stagflation.

Our take

The soft landing was always more narrative than forecast, a story markets told themselves because the alternative was too unpleasant to price. May's PCE data does not guarantee a hard landing, but it does confirm that the runway is shorter than advertised. The Fed will likely hold rates at its July meeting while issuing hawkish guidance, but the real test comes in September. By then, either inflation will have resumed its decline or Powell will face a choice between his credibility and the economy's near-term comfort. History suggests he will choose credibility. History also suggests that choice will hurt.