Markets should pay close attention to the Cleveland Fed's Inflation Nowcast model, which signals that inflation risks are tilting decisively to the upside.

With energy markets serving as the primary catalyst, the path back to the Fed's 2% inflation target looks increasingly precarious. Rising gasoline prices have squeezed household budgets and fixed income markets have begun pricing in the possibility that the Federal Reserve will have to hike rates to combat the advance. With the Iran conflict still unresolved and domestic commercial oil inventories declining at an accelerated rate to meet both export demand and domestic consumption, the pass-through of higher energy prices to other goods and services is starting to gain traction, especially as we head into the summer driving season.

The Cleveland Fed's Inflation Nowcasting model is now estimating Personal Consumption Expenditures (PCE) to rise above 4% in May (with the report scheduled for release in June). Obviously, this is not the direction of inflation Fed members would like to see at this juncture; PCE captures household spending including items not captured by CPI, accounts for roughly two thirds of domestic spending and is a big driver of GDP. Of equal concern is that the rate of change is starting to accelerate, and the PCE Price Index is generally considered a more stable measure of inflation than CPI or PPI.

CPI tracks prices paid by urban households for a fixed basket of goods and services over time, with a core figure that strips out food and energy price volatility. The Producer Price Index measures the average change in prices received by domestic producers of goods and services. The last time PCE moved above the 4% level was in 2023, when the residual effects of Covid-19 supply disruptions, combined with fiscal spending, were still working through the system.

That said, if a resolution to the Iran war is found soon and traffic begins to pick up in the Strait of Hormuz, the inflationary pressure could prove short-lived. However, with the summer driving season hitting full swing and weekly oil inventory draws reaching record highs, particularly for medium and sour crude used in gasoline refining, the supply buffer is quickly eroding.

Investors and policymakers alike should brace for a data-dependent summer in which geopolitical headlines out of the Middle East and weekly EIA inventory reports may carry as much weight as the official inflation prints themselves. Until the supply-side pressures in crude markets ease, the Fed's optionality on rate cuts narrows—and the possibility of a hawkish pivot, while still a tail risk, can no longer be dismissed.

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