Today’s inflation report reflects ongoing price pressures tied to the Middle East conflict, though the impact remains relatively contained. Headline inflation, primarily driven by energy, rose 0.5% in May, as expected, lifting the annual rate to 4.2%, the highest in over three years. However, inflation concerns were eased by goods deflation and a lower-than-expected Core CPI reading of 0.2%. Even so, the fluid situation in the Middle East suggests the risk of higher energy prices for longer, along with second-round inflation impacts, persists.
Headline inflation rose 0.5% in May, as expected, lifting the annual rate to 4.2%, an uncomfortably high level after almost three years below 4%. Energy was the primary driver, accounting for 60% of the increase, as the ongoing Middle East conflict continues to push oil and gas prices higher. Still, the 3.9% increase in energy prices was far more modest than March’s 10.9% surge. With no resolution to the Middle East conflict, a near-term return to pre-war energy price trends seems unlikely.
Core inflation, which excludes food and energy, rose 0.2%, slightly below expectations for a 0.3% gain, offering some reassurance that the conflict’s impact remains contained, giving the Fed room to pause. Still, core’s annual rate of close to 3% and further drift away from policymakers’ 2% target should not be dismissed.
Food prices eased from last month, rising only modestly after April’s sharp increase. Four of the six major grocery categories posted gains, down from five last month. However, the risk remains that the conflict lifts fertilizer costs, eventually feeding through to food prices.
Goods inflation declined slightly, marking the first monthly negative reading in goods prices since last year’s trade escalation. The softness was broad-based, with medical care commodities, household furnishings and supplies, and new vehicles and parts as key contributors. Categories that saw sharp increases in April—apparel and tech commodities—also cooled, suggesting tariff pressures may have largely run their course. While uncertainty around trade policy persists, the tariff effect is expected to continue to fade ahead.
Core inflation was again driven primarily by services. Shelter costs, particularly owner’s equivalent rent, rose in May but eased from April’s sharp increase. Notably, April’s increase reflected more of a convergence following understated readings due to limited data collection during the shutdown, rather than a true spike. As such, this category should still be interpreted with caution.
Outside of shelter, communication and medical services were the main drivers of price acceleration, reversing last month’s declines. Transportation services eased, led by declines in vehicle rental and insurance, providing some relief for households. Airline fares, which are energy-sensitive, rose again, reflecting higher fuel costs from the conflict, though the pace has not accelerated since March.
The Fed’s preferred supercore inflation measure rose 0.3%, lifting the annual rate to 3.7% from 3.4%. The data suggest that wage-driven services inflation remains sticky, though still far from a wage-price spiral.
Policy outlook
Today’s acceleration in inflation was no surprise, given that the ongoing Middle East conflict has kept energy prices elevated. Still, inflation concerns were tempered by little evidence of broader second-round effects from the war, alongside a slightly softer-than-expected core reading. That said, core’s edge higher toward 3% and further drift from the Fed’s target suggests investors are not out of the woods on inflation.
As such, the Fed is likely to proceed with caution in the months ahead, acknowledging that while energy spikes can be temporary, supply chain disruptions risk more persistent inflation, as seen during the pandemic. Given these lingering risks, markets are already pricing in one Fed hike this year. By contrast, our base case for no cuts in 2026 is slightly more dovish, as the absence of a wage-price spiral—as shown in last week’s jobs report—allows the Fed to maintain a data-dependent stance.
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