The PCE-CPI Gap and the Outlook for Further Fed Tightening

The Fed's recent rate hike may have been premature. While core CPI inflation at 2.4% is acceptable, core PCE inflation is running hotter. This divergence, unusual over the last 40 years, has widened significantly.

The gap is largely driven by differing weights in shelter and financial services, plus a sharp swing in auto insurance costs. However, these factors appear temporary. Shelter inflation is moderating, software inflation should fade, a methodology change will likely reduce financial services' impact, and auto insurance is reversing.

We expect PCE inflation to fall more than CPI as these anomalies resolve. This should allow the Fed to pause after one more hike in December, setting policy at 4.00%-4.25% for 2027. This outcome is less tightening than markets anticipate, supporting risk assets.