Brace for a Bumpier Inflation Path

• The average price for a gallon of gasoline rose 41% in May.

• Regional Fed prices received data was little changed compared to last month.

• The scenario could drive real rates of interest even lower.

The inflation picture is going to get messier before it starts to improve…

This week delivers a key update for investors tracking the Federal Reserve’s monetary policy outlook. The U.S. Bureau of Labor Statistics (“BLS”) will release its May Consumer Price Index (“CPI”). And if you’ve filled up your tank recently, you already know the setup: headline inflation is headed higher.

According to the Energy Information Administration (“EIA”), the average gallon of gasoline last month cost $4.61. That’s the highest level since mid-2022, when inflation was retreating from a four‑decade peak. It also marked a 41% jump from May 2025…  

As the chart above shows, the first quarter typically produces the fastest annualized price growth of the year. But this past month far exceeded the typical 5% gain for May. The move pushed the Cleveland Fed’s staff to project headline CPI could reach 4.2%, a level we haven’t seen since late 2023. That shift has stoked Wall Street’s anxieties about whether rate hikes will re‑enter the discussion.

New Chairman Kevin Warsh has signaled out central bank is willing to be patient for a little while longer. Recent commentary from other policymakers indicate their anxieties are up, but they’re hoping the White House can resolve the Iran conflict soon enough to prevent oil prices from staying elevated and feeding inflation. Based on the data I track, the recent jump in energy costs hasn’t yet filtered into broader goods and services prices. That gives the Fed room to stay on hold for a little while longer, but patience is wearing thin.

But don’t take my word for it, let’s look at what the data’s telling us…

To get an idea of what inflation growth might look like each month, I built a gauge using monthly manufacturing and services index data from the Dallas, Kansas City, New York, and Philadelphia Fed districts. These surveys ask businesses whether activity is rising, falling, or holding steady, and then publish indexes to capture the change. Together, these regions represent roughly 32% of national economic output. I focus on the “prices received” components because they serve as a proxy for CPI.

Each district is weighted by its contribution to national growth, giving us a cleaner read on how they influence the overall picture.

• In May, the combined manufacturing prices‑received index came in at 31.3

• That was up from 31 in April.

• That’s back to levels we experienced in early 2025 when price growth last hovered around 3%…  

Manufacturing, however, accounts for only about 10% of domestic output. Services matter far more. That sector includes healthcare, education, finance, hospitality — the parts of the economy where most Americans work and spend.

• My gauge shows the services index fell to 19.3 in May.

• That compares to 20.5 in April.

• That’s still within the range of recent outcomes.

Next, I blended the two measures, weighting them by economic importance and their relevance to CPI. Because services dominate the U.S. economy, they carry more sway in the combined reading.

• The composite came in at 23.5 for May.

• That compares to 24.2 in April.

• This is above the recent range, but not terrible.

This matters because it tells the Fed that companies are raising prices on consumers. They’re likely passing on the elevated fuel costs from the last few months. In fact, the details show Philadelphia accounted for the bulk of the increase, while gauges eased in Dallas, Kansas City, and New York. Policymakers still have cover to look past the gas‑price spike before making any interest rate moves, but their tolerance is likely wearing thin if prices keep surging.

So, the last step is to measure the Fed’s interest rate cushion. We can do this by looking at the real rate of interest (effective federal funds rate minus inflation). A positive number means policy is weighing on price growth, while a negative number means rates are stoking inflation. According to the most recent CPI figures, rate hikes aren’t yet necessary…

In May, the effective federal funds rate was roughly 3.6% while inflation stood at 3.8%. That means policy is about 20 basis points below the so‑called neutral level, where rates neither help nor hinder growth. And since the Fed has managed the real rate to an average of –0.6% since 2000, it implies policymakers have 40 basis point cushion before reaching that long‑term norm.

Now let’s apply the Cleveland Fed’s 4.2% CPI estimate. Under that scenario, the current rate‑cut cushion drops to just -0.6%. When we factor in the long‑term average, it tells us the Fed is running out of wiggle room.

Bottom line: the margin for rate cuts is all but gone. The Fed still has room to stay on hold, but policymakers’ anxieties are up. However, if the situation in the Middle East keeps dragging on, the door to lower borrowing costs could be gone for at least the rest of this year.

Yet, there’s still optimism looming on the horizon. Gas prices have already started to pull back in June with the national average so far having dropped 3.6%, leading the Cleveland Fed to estimate annualized CPI will pull back to 4%. Such an outcome would provide our central bank with a bit of a cushion once more. The shift would help sustain a steady, long‑term rally in the S&P 500.

Five Stories Moving the Market:

U.S. President Donald Trump told Israeli Prime Minister Benjamin Netanyahu not to retaliate against Iran's missile attack and allow more time for diplomacy, according to senior U.S. and Israeli officials – AXIOS. (Why you should care – the White House still feels talks are on track to reach a broader agreement with Iran and end hostilities)

Mohsen Rezaee, a military adviser to Iran’s supreme leader, said recent missile launch toward Israel were a “warning to cease their hostile actions” in Lebanon; the statement came after Hezbollah and Israeli military forces clashed in northern Israel and southern Lebanon - Bloomberg. (Why you should care – the exchange appears more business as usual rather than damaging truce negotiations between Washington and Tehran) 

One of the main roadblocks to a peace deal between the U.S. and Iran is that Tehran wants early access to cold, hard cash, and it is politically hazardous for President Donald Trump to agree; a decision to free Iran’s assets upfront would inevitably generate comparisons to Trump’s criticism of the Obama administration for flying cash into Tehran in the hours after the nuclear accord was implemented in January 2016 – WSJ. (Why you should care – Iran is seeking $12 billion immediately and $24 billion during a 60-day negotiating window)

SpaceX said it has entered into a multi-year cloud services agreement with Alphabet's Google, locking in computing capacity as it prepares for its highly anticipated ‌U.S. stock market debut; as part of the deal, Google will pay SpaceX $920 million monthly from October this year to June 2029, with capacity ramping up through ​September at a reduced fee – Reuters. (Why you should care – the deal highlights the increased demand for compute capacity while supply continues to lag)

Hiring has surged this spring, with employers adding more than half a million jobs between March and May; factories, restaurants and city halls have all shifted into hiring mode, a pivot from last year, when the healthcare industry almost single-handedly propped up job creation – WSJ. (Why you should care – even though hiring numbers are still below typical seasonality, the rebound is stoking speculation of potential rate hikes)

Economic Calendar:

Earnings: CPB, FCEL, MPAA, MTN

Fed’s Barr (Board Member, Voter) Speaks (Saturday)

Japan – GDP for Q1Germany – Factory Orders for April (2 a.m.)

Eurozone – Sentix Investor Confidence for June (4:30 a.m.)

U.S. – New York Fed Consumer Inflation Expectations for May (11 a.m.)

Treasury Auctions $89 Billion in 13-Week Bills (11:30 a.m.)

Treasury Auctions $77 Billion in 26-Week Bills (11:30 a.m.)