Hot Core, Cold Wallets: September Rate Cut Still Persist

The May 2025 Personal Consumption Expenditures (PCE) report landed slightly hotter than expected on a core basis, though financial markets appeared to take the news in stride. While headline inflation aligned with forecasts, a modest upside surprise in core PCE highlighted lingering price pressures. Despite softer consumer spending and income data, the market held firm, buoyed by dovish commentary from Minneapolis Fed President Neel Kashkari, who reiterated expectations for two rate cuts this year, potentially starting in September.

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Headline PCE rose 0.1% month-over-month, matching consensus estimates and in line with April’s revised print. Year-over-year, the index ticked up to 2.3% from a revised 2.2%, consistent with expectations. However, core PCE—the Fed’s preferred inflation gauge, excluding food and energy—rose 0.2% month-over-month, above the 0.1% consensus and April’s 0.1% reading. On an annual basis, core PCE increased 2.7%, one-tenth above the consensus and April’s revised 2.6% level.

Consumer spending showed notable weakness in the report. Current-dollar personal consumption expenditures fell 0.1%, versus expectations for a 0.1% gain. In real terms, spending declined by 0.3%, the sharpest drop since January. Personal income also disappointed, falling 0.4% in May, compared to expectations for a 0.3% increase. Disposable personal income (DPI) declined by 0.6%, and real DPI contracted by 0.7%. The personal saving rate dropped to 4.5%, down from 4.9% in April.

The decline in spending was driven by a steep $49.3 billion drop in expenditures on motor vehicles and parts, the largest single category drag. Gasoline and other energy goods followed with a $19.8 billion decline. Food services and accommodations spending dropped $10.6 billion, and other categories such as financial services (-$5.7B), transportation services (-$4.0B), and food and beverages (-$1.8B) also weakened. On the flip side, services held up better: housing and utilities rose by $13.7 billion, healthcare increased by $11.3 billion, and nondurable goods rose $8.6 billion.

Despite the inflation surprise, financial markets were unfazed. Equity futures rose ahead of the open, with the S&P 500 nearing an all-time intraday high, supported in part by optimism around trade developments. Commerce Secretary Howard Lutnick confirmed that the U.S.-China trade framework finalized in Geneva was officially signed, while discussions of multiple new trade deals buoyed sentiment further. Bond yields ticked higher, but Fed funds futures barely moved, with markets still pricing in roughly two rate cuts this year.

Kashkari's comments provided key reassurance. Speaking after the data, he noted that while inflation could receive a boost from tariffs, actual price data still showed progress toward the 2% target. He reiterated that the Fed remains data-dependent and could pause easing if the impact of tariffs proves greater than expected. However, he maintained that September remains a plausible starting point for rate cuts if inflation remains steady.

The Fed's challenge remains one of balance: navigating a landscape where headline inflation remains rangebound, core inflation resists further downside, and economic momentum appears to be cooling. The mixed data from the May PCE report provides both hawks and doves with ammunition. Goods prices were essentially flat year-over-year, while services prices rose 3.4%, continuing to drive the bulk of inflation.

With Powell emphasizing caution and patience, the data suggests the Fed is still in wait-and-see mode. June CPI (due July 15) and PCE (July 31) reports, followed by July inflation data in August, will be pivotal. For now, market participants remain focused on softening economic activity, inflation trends, and geopolitical risks as they position ahead of the Fed's next move.