PCE Inflation in Line with Expectations: Implications for Fed Policy and Equities

The release of the October 2025 U.S. Personal Consumption Expenditures (PCE) inflation data on December 5, 2025, confirmed a mixed but cautiously optimistic picture for the Federal Reserve's policy trajectory. Core PCE inflation, the Fed's preferred gauge, came in at 2.8% year-over-year, aligning with market forecasts and reflecting a slight deceleration from prior months. While this marks progress in the disinflationary trend, the figure remains above the central bank's 2% target, underscoring the delicate balancing act the Fed faces as it navigates the path to rate cuts in 2026. For investors, the data reinforces the need for strategic positioning ahead of potential policy shifts and evolving market dynamics.

Core PCE: A Gradual Cooling, But Services Remain a Challenge

The October PCE report highlighted divergent trends across components of the inflation basket. Core PCE, which excludes volatile food and energy prices, held steady at 2.8% annually, consistent with expectations. This figure reflects a modest slowdown compared to earlier readings, driven by continued moderation in goods prices and stable energy costs. However, services inflation-particularly in housing and supercore services (services excluding housing and energy)-remains stubbornly elevated. These components, which constitute a significant portion of the core PCE basket, signal persistent domestic demand pressures that could delay the Fed's timeline for achieving its inflation target.

The Cleveland Fed's inflation nowcasting model provides further context, projecting a gradual decline in core PCE inflation toward 2% by mid-2026 under baseline assumptions. This trajectory suggests that while the Fed may tolerate a slower-than-expected disinflation process, it will remain vigilant against any signs of reacceleration, particularly in services. Investors should monitor the three-month annualized core PCE pace, which offers a clearer view of inflationary momentum than single-month readings.

The October FOMC minutes revealed heightened scrutiny of services inflation and labor market indicators, with policymakers acknowledging the risk of premature easing. This suggests that while the Fed is inclined to cut rates in 2026, the pace and magnitude will depend on whether inflation trends align with its projections. For now, markets are pricing in a gradual reduction in rates, with the first cuts likely in early 2026.

Equity markets have responded to the PCE data with a mix of optimism and caution. The S&P 500 has shown resilience, reflecting investor confidence in the Fed's ability to manage inflation without triggering a recession. However, the path forward is not without risks. A potential upside surprise in PCE data-such as a sharper-than-expected rise in services inflation-could delay rate cuts and strengthen the U.S. dollar, creating volatility for risk assets. Conversely, a more favorable inflation report could bolster risk-taking, particularly in sectors sensitive to interest rates, such as technology and real estate.

Investors should also consider the broader implications of the Fed's decision to halt its balance sheet runoff by December 1, 2025. This move aims to stabilize liquidity amid ongoing Treasury debt issuance and potential strains in repo markets. By maintaining ample liquidity, the Fed is indirectly supporting asset valuations, which could benefit equities in the near term.

Strategic Positioning for 2026

Given the Fed's data-dependent approach and the uneven inflation landscape, strategic positioning should prioritize flexibility and sectoral diversification. Sectors poised to benefit from rate cuts-such as consumer discretionary, real estate, and high-yield equities-remain attractive, but exposure should be balanced with defensive positions to mitigate volatility. Additionally, investors may want to hedge against potential dollar strength by incorporating non-U.S. equities or commodities into their portfolios.

The key takeaway is that the Fed's policy path will remain contingent on incoming data. While the October PCE report provides a cautiously optimistic outlook, the road to 2% inflation is still long. Investors who position for a gradual, measured easing cycle-while remaining agile to shifting economic signals-will be best positioned to navigate the uncertainties ahead.