Inflation Risks Linger as July PCE Data Arrives

July's Consumer Price Index (CPI) data offered a reprieve, not an all-clear.

The Federal Reserve got some breathing room as the CPI showed inflation broadly cooling. The probability of a rate hike at the Fed's September meeting has dropped to 35% as of August 18, according to the CME FedWatch Tool. But the market still sees a 68% chance of a hike by the end of the year, while U.S. Treasury yields have hit long-term highs, underscoring how little was resolved by the most recent CPI data.

Personal Consumption Expenditures (PCE) data due August 26 will offer a second, somewhat broader snapshot of the current state of inflation, which remains elevated and uneven, with price pressures flowing through multiple channels.

With three Fed policymakers having already voted for a rate hike in July, any hotter-than-expected readings in coming months could tip the balance toward a rate increase, especially since inflation has exceeded the Fed's 2% target for five straight years.

Oil likely remains the clearest near-term inflation risk. Energy prices fell 1.5% in July from a month earlier, helping drive headline inflation lower. U.S.-Iran negotiations toward a peace deal have yielded very little, and The Wall Street Journal has reported that Iran is actually preparing for a longer war—one its hardline leadership sees as an opportunity to solidify power and weaken the United States in the region.

Oil prices could spike again if it appears the Strait of Hormuz will be closed indefinitely. In fact, oil and gasoline rose again in late July, keeping energy prices a risk heading into August.

It's not just oil that bears watching. Core CPI, which excludes food and energy, rose 0.2% in July from a month earlier, and 2.5% from a year ago. Both met expectations. But core goods rebounded in July, rising 0.2% from a month earlier. That ranked as the largest increase since September 2025, likely driven partly by categories tied to the AI capital-spending spree. Computer software and accessories rose 0.5% from a month earlier (and 21% from a year earlier), while computers, peripherals, and smart home assistants rose 3.5% from June.

Computer software and accessories account for a much larger share of overall core PCE than of core CPI, so they may help push PCE higher.

The services sector remains a consistent source of inflationary pressure and has been largely responsible for inflation remaining elevated in recent years. Expenses related to health care were among the biggest drivers. The medical care index rose 0.4% from a month earlier, while hospital services jumped 0.5%. The PCE's health care gauge, which is broader than the CPI's, will be worth monitoring for a more comprehensive view.

While CPI shelter prices rose a subdued 0.1% from a month earlier, that was largely due to a 2.8% decline in lodging prices. Rent and owners' equivalent rent each rose 0.3%. In any case, the benign CPI shelter reading may not translate to PCE, which gives less weight to shelter.

Consumer health is always a key part of the inflation picture, and today that reading is clouded. Real consumer spending jumped 3.2% at an annualized rate during the second quarter, according to advance gross domestic product estimates. That suggests the kind of demand that might cause some businesses to conclude that consumers are able and willing to pay higher prices—and to pass them along.

Still, the Employment Cost Index, a broad gauge of labor costs, rose only 0.9% in the quarter, not enough to raise serious concerns about a wage-price spiral. Wages and salaries rose 3.2% year over year, the smallest annual gain since 2021.

The latest retail sales data also complicates the outlook, having fallen for the first time in nine months in July. The reading came in well below expectations, though results were partly weighed down by lower gas prices and Amazon (AMZN) moving its Prime Day to June this year after holding it in July last year.

PCE data on real spending, real disposable income, and the savings rate may offer helpful details about the health of U.S. consumers.