U.S. Core PCE Inflation Rises to 2.7%, Exceeds Forecasts

June 27, 2025 — U.S. core inflation, as measured by the Core Personal Consumption Expenditures (PCE) Price Index, rose to 2.7% year-over-year (YoY) in May, outpacing economists' expectations of 2.6%. This reading adds fuel to debates over Federal Reserve policy and sector-specific investment strategies as markets grapple with inflation's dual impacts.

Introduction

The Core PCE Index, the Federal Reserve's preferred gauge of underlying inflation, signals whether price pressures are easing or intensifying. With the Fed prioritizing price stability amid a tightening labor market, this data's surprise upward shift reignites concerns over monetary policy direction. Analysts now question if the Fed will adopt a more hawkish stance or hold rates steady to avoid stifling growth.

Data Overview and Context

Source: U.S. Bureau of Economic Analysis
The Core PCE strips out volatile food and energy components, offering a clearer view of “core” inflation.

Analysis of Underlying Drivers and Implications

Higher inflation reflects sticky services prices (e.g., housing, healthcare) and resilient consumer demand. While elevated inflation typically dampens discretionary spending, the data's surprise has sharpened focus on infrastructure investment. Policymakers may accelerate public works projects to offset economic cooling risks, benefiting construction firms.

The May data shows housing services inflation (a major PCE component) rose to 4.2% YoY, driven by lingering rent hikes from 2023. Meanwhile, healthcare costs, which account for 18% of the PCE basket, climbed 3.4%, outpacing wage growth for many households. These trends suggest that even as goods inflation eases, services costs remain a key inflation driver.

Policy Implications for the Federal Reserve

The Fed will balance this inflation data against weak manufacturing and softening job growth. A pause in rate hikes remains likely, but the Core PCE's upward surprise could prompt officials to signal readiness for further tightening if inflation persists. Fed Chair Powell has emphasized that “data dependence” will guide policy, with June's FOMC statement noting “heightened uncertainty around inflation's path.”

The Fed's June projections already forecast Core PCE to average 3.1% in 2025, down from 3.4% in March. The May surprise brings actual inflation closer to the upper end of that range, increasing pressure on policymakers to avoid complacency.

Market Reactions and Investment Implications

• Equities: Construction and Engineering stocks (e.g., Larson & Toubro (LTE.N), Bechtel Group, and infrastructure ETFs like XLE) surged post-data, aligning with the backtest's bullish signal. Investors are pricing in fiscal stimulus for transportation and energy projects to offset economic headwinds.
• Fixed Income: Treasury yields climbed, with 10-year notes up 6 bps to 3.85%, reflecting inflation risks. The 2-year yield, more sensitive to Fed policy, rose 4 bps, narrowing the yield curve.
• Currencies/Commodities: The U.S. dollar strengthened modestly against the euro (+0.3%) and yen (+0.5%), as inflation data reinforced its status as a safe-haven asset.

Investors should overweight Construction & Engineering sectors, particularly firms tied to infrastructure projects. The S&P 500 Construction & Engineering Index (XLI) has outperformed the broader market by 5% year-to-date, and the surprise reading could extend this trend. Avoid consumer discretionary equities (e.g., Amazon (AMZN), Walmart (WMT)), which face margin pressures from higher input costs.

Conclusion & Final Thoughts

The Core PCE's surprise highlights inflation's persistence amid a mixed economic backdrop. Markets now await July's employment data and the Fed's July meeting for clarity on policy. For investors, the construction sector's outperformance post-surprise underscores the need to pivot toward inflation-resistant assets.

The backtest results reveal a notable bullish impact on the Construction and Engineering industry following Core PCE Price Index readings above expectations, sustained over 59 days. This indicates elevated inflation spurs increased investment in infrastructure and real assets. The analysis further explains that while higher inflation dampens consumer discretionary demand, leading to bearish effects elsewhere, the Construction and Engineering sector benefits from economic overheating signals. Investors may consider overweighting Construction and Engineering sectors after such inflation surprises to capitalize on infrastructure-driven growth amid tightening monetary policy environments.

Nick Timiraos