Recent government data show that inflation remains well above the U.S. Federal Reserve’s 2.0% target level, with little sign of coming down soon. Unless there is a substantial deterioration in the overall economy—especially the employment situation—the Fed is highly unlikely to lower short-term interest rates in 2025 beyond its most recent projection of two reductions of a quarter percentage point each.

Looking at inflation

The conventional way of stating inflation, namely, the rate of change from a year earlier, can be somewhat misleading when prices increase dramatically in relatively short periods of time. As for where inflation is headed in the next few months, investors are more interested in the underlying trend in recent months than in what happened, say, 11 or 12 months ago. Thus, when inflation is high and volatile, it may be preferable to look at recent month-over-month changes, rather than year-over-year changes. An elevated reading in a single month can be safely ignored because it can easily change the next month, but a series of readings that consistently deviate from the Fed’s target level for inflation should be a cause for concern.

The Fed’s preferred inflation gauge

The price index the Fed watches most closely, the rate of change in core personal consumption expenditures (PCE), has steadily increased the past three months at a pace well above the Fed’s target level. In December, January, and February, this metric—stated on an annualized basis—clocked in at 2.6%, 3.6% and 4.5%, respectively. It’s worth noting that the Fed tends to focus on PCE data rather than the more commonly known Consumer Price Index, in part because the PCE is arguably a better reflection of consumers’ spending patterns, including changes in these patterns due to fluctuations in prices.

As Figure 1 shows, according to PCE data, inflation has declined significantly from its peak in 2021, and in particular after the Fed began tightening monetary policy in March 2022. Since then, however, progress has stalled, and inflation remains stuck above the Fed’s target rate as noted above. Economists tend to disagree about what should be the optimal level of inflation. Former Fed chair Paul Volcker may have said it best when he expressed that inflation should be low enough that people pay no attention to it, so that it does not distort their spending and investment decisions. Considering inflation remains top of mind for many consumers, the Fed has work to do on this front.

Fig. 1. Monthly rate of inflation of core Personal Consumption Expenditures (%)

Impact of consumers’ perceptions of inflation

Fed officials are well aware of a vicious cycle, namely that actual inflation levels affect  expectations of future inflation, and those expectations in turn affect the actual rate of inflation. The fact that inflation has lingered at elevated levels for several years may be why inflation expectations have spiked again, based on the University of Michigan’s consumer survey (Fig. 2). On the other hand, consumer expectations tend to fluctuate, and other indicators of inflation expectations aren’t quite as ominous.

Fig. 2. Inflation expectations (%)

Waiting on the Fed

For now, Fed officials appear to remain hesitant to publicly acknowledge this recent trend—Fed chair Jerome Powell recently referred to the University of Michigan survey as an “outlier.” However, the spike in inflation expectations is a genuine cause for concern. Barring a sudden deterioriation in the U.S. economy, the Fed is unlikely to resume the path of monetary easing it began in 2024 as long as inflation and inflation expectations remain elevated.

Jerry H. Tempelman is Vice President of Fixed Income Research at Mutual of America Capital Management LLC.