For most of 2024 and the first half of 2025, the inflation story in America was one of steady, if occasionally uneven, progress. The Federal Reserve had raised interest rates to their highest level in two decades, and the medicine appeared to be working. Core PCE, the central bank's preferred gauge of underlying price pressures, fell from a peak of 5.6% in early 2022 all the way down to 2.6% by mid-2025. The "last mile" to the Fed's 2% target seemed within reach.
That narrative shattered on Thursday when the Bureau of Economic Analysis reported that core PCE inflation rose 3.0% year-over-year in December 2025, up sharply from 2.8% in November and marking the fastest pace in nearly a year. On a month-over-month basis, core prices increased 0.4%, double the 0.2% pace from November and well above the 0.2% that economists had forecast.
The Numbers Behind the Reacceleration
The headline PCE price index rose 2.9% year-over-year and 0.4% month-over-month. But it was the core reading, which strips out volatile food and energy prices, that sent the strongest signal to markets and policymakers. At 3.0%, core PCE is now a full percentage point above the Fed's target, and the trajectory is moving in the wrong direction for the first time since the tightening cycle began.
Services inflation remains the primary culprit. Housing costs, healthcare services, and financial services all contributed to the acceleration. Shelter costs, which have been stubbornly slow to reflect the cooling in real-time rent data, showed no meaningful deceleration in December. Insurance premiums, a category that has confounded forecasters for over a year, continued to climb at an annualized rate well above 5%.
Goods prices, which had been in outright deflation for much of 2024, also showed signs of firming. Part of this reflects the front-loading of imports ahead of tariff deadlines, a dynamic that has distorted trade and consumption data throughout the fourth quarter. But part of it also reflects genuine cost pressures that are working their way through supply chains as input costs stabilize at elevated levels rather than continuing to fall.
What the Consumer Spending Data Tells Us
The same report showed that personal consumption expenditures increased $91 billion, or 0.4%, in December. Personal income rose $86.2 billion, or 0.3%. The saving rate edged down to 3.8%, near its lowest level in nearly two years. In plain terms, Americans are spending more than their incomes are growing, and they are drawing down savings to do it.
This combination of rising prices and resilient spending is precisely the dynamic the Fed feared when it paused rate cuts last summer. Consumer demand, while not booming, remains firm enough to sustain price pressures in service-oriented sectors of the economy. The labor market, with unemployment holding near 4.1%, is providing enough income growth to keep consumption afloat even as real wages grow at a diminished pace.
The problem for policymakers is that this spending resilience removes the demand-side pressure that would help bring inflation lower. In the absence of a meaningful economic slowdown, prices in services sectors have little incentive to moderate.
The Fed's January Minutes Now Make More Sense
When the Federal Reserve released the minutes from its January 28-29 meeting earlier this week, several passages stood out. Multiple officials noted that "progress on disinflation had stalled" and that "the risks to the inflation outlook had shifted to the upside." Several participants went further, stating that rate increases "could become appropriate if inflation proved persistent."
At the time, some market observers dismissed this language as posturing designed to keep financial conditions tight. The PCE report suggests it was something more consequential: a genuine shift in the committee's risk assessment. With core PCE at 3.0% and trending upward, the idea of rate cuts in 2026 is becoming increasingly difficult to justify.
Fed funds futures now price in fewer than two quarter-point rate cuts for the remainder of 2026, down from more than four at the start of the year. The probability of a cut at the March meeting has collapsed to just 5%, down from 35% as recently as January. Some traders have even begun pricing in a small probability of a rate hike by mid-year, something that seemed unthinkable just weeks ago.
The "Last Mile" Problem in Historical Context
The concept of the "last mile" in disinflation is not new. During the 1990s, after the Volcker-era rate hikes had crushed the worst of 1970s-style inflation, it still took nearly a decade for core PCE to settle sustainably at or below 2%. The journey from 4% to 3% happened relatively quickly. The journey from 3% to 2% was far more protracted, marked by false starts, temporary reversals, and extended periods of stagnation.
The current episode bears uncomfortable similarities. Getting from 5.6% to 3.0% required aggressive monetary tightening and a once-in-a-generation normalization of supply chains. Getting from 3.0% to 2.0% may require something the Fed has so far been unwilling to deliver: a recession, or at least a period of below-trend growth sustained long enough to genuinely cool the labor market.
The fourth-quarter GDP report, released the same day as the PCE data, showed the economy grew at just 1.4% annualized, well below the 2.5% consensus. But even that slowdown, driven partly by a government shutdown and inventory drawdowns, was not enough to prevent inflation from accelerating. The implication is stark: the economy may need to slow considerably more before price pressures truly subside.
What This Means for Markets and Portfolios
The bond market's reaction was swift and telling. The 2-year Treasury yield, which is most sensitive to near-term rate expectations, jumped 8 basis points on Thursday, briefly touching 4.35% before settling back. The move reflected a rapid repricing of the probability that the Fed's next move could be a hike rather than a cut.
For equity investors, the implications are more nuanced but equally important. Higher-for-longer interest rates compress the valuations of growth stocks, which derive more of their value from future earnings. The S&P 500's forward price-to-earnings ratio, currently hovering near 22 times, looks increasingly stretched if the risk-free rate remains at or above current levels through year-end.
Real estate investors face perhaps the most direct impact. The 30-year mortgage rate, which had fallen to 6.01% earlier this week, is unlikely to sustain that decline if the Fed signals it may need to tighten further. The spring housing season, which many industry observers were counting on to revive transaction volumes, may prove more muted than hoped.
The Policy Bind
The Fed now faces a dilemma with no comfortable resolution. Cutting rates would risk further inflaming inflation at a moment when the data says price pressures are reaccelerating. Holding rates steady may not be enough to bring inflation down if the economy continues to grow, even slowly. Raising rates would tighten financial conditions into an already decelerating economy, risking the kind of policy-induced recession that Fed Chair Jerome Powell has spent three years trying to avoid.
Adding to the complexity is the political calendar. Powell's term as chair expires in February 2028, but the White House has already nominated Kevin Warsh as his replacement, with a transition expected later this year. The prospect of a leadership change adds uncertainty to an already volatile policy landscape and raises questions about whether the Fed will have the institutional resolve to make unpopular decisions in a midterm election year.
For now, the message from Thursday's PCE report is unambiguous. The easy part of the disinflation campaign is over. The hard part, the last mile, is proving to be longer and more treacherous than almost anyone expected. And until the data changes, investors should plan for an environment where interest rates stay higher, for longer, than the optimists have been willing to believe.
