The U.S. economy registered a notable pickup in core inflation in July, with the personal consumption expenditures (PCE) index excluding food and energy rising to 2.9% year-over-year — the strongest reading since February. Behind the headline number is a convergence of forces: the delayed pass-through of import tariffs into consumer prices, persistent services inflation — especially housing and labor-intensive services — and surprisingly firm consumer spending and income. Together these dynamics helped push underlying inflation higher even as energy and many goods categories showed moderation.

Economists and market participants have been closely watching the core PCE because it strips out the most volatile components and is the Federal Reserve’s preferred gauge for assessing underlying price pressures. The July jump complicates the Fed’s decision calculus: while some indicators point toward a cooling labor market that could justify rate cuts, the stickiness in services and evidence of tariff pass-through suggest that inflation is not yet back on a clear downward path.

Tariffs and import-price pass-through

One important mechanical channel behind July’s rise was the effect of tariffs on import prices. Earlier policy actions raised duties on a broad swath of imports, and those higher costs have gradually moved through supply chains. Retailers and wholesalers initially absorbed some tariff costs to protect market share, but as inventories turned over and shipping dynamics tightened, more of the burden has been pushed onto final consumers. This pass-through shows up in core goods prices and in intermediate input costs that firms pass into services prices over time.

Moreover, changes to low-value import rules and new reciprocal tariffs on particular trading partners have altered the price structure for many everyday items. When import costs rise for components or finished goods, manufacturers face choices: eat the cost, raise prices, or cut margins. The recent data suggest an increasing tendency to pass costs on, contributing to the modest but meaningful lift in core measures.

Services and shelter: the sticky heart of core inflation

The dominant and most persistent contributor to the July increase was the services sector — notably shelter, healthcare, professional services, and other labor-intensive categories. Shelter costs, which are slow to respond to cyclical shifts, have been a steady driver of underlying inflation. Rent and owner-equivalent rent adjust with long lags because leases and housing inventories change slowly; as a result, shelter can sustain inflation momentum even when goods prices cool.

Wage dynamics play into this as well. Many services are labor-intensive, and continued wage growth in consumer-facing industries — from restaurants to healthcare and logistics — feeds into higher service prices. Firms facing higher payroll costs often pass these on, especially in sectors where labor is a major component of cost and where pricing power exists. In July, the services pocket of the economy showed continued resilience, offsetting weakness in many goods categories and accounting for most of the monthly gain in the core PCE.

Consumer spending remained robust

Another key element was the resilience of consumer demand. Personal consumption increased in July, supported by steady income growth and a still-favorable jobs backdrop in numerous sectors. When households keep spending — particularly on services like travel, dining, and health care — businesses find it easier to maintain or raise prices rather than offer discounts. That sustained demand helps explain why services inflation remained elevated and why goods price pressures were not sufficient to pull the core reading down.

Spending strength also means higher utilization of services that have limited short-run supply elasticity. For example, travel and leisure can tighten quickly in peak seasons, giving providers the ability to raise rates. Healthcare costs, driven by both wage and technology factors, are another area where demand proved less responsive to price gains. The net effect in July was a consumption pattern that supported inflation rather than cooling it.

Supply frictions and the goods/services divergence

While headline inflation was restrained by a decline in energy prices, the split between goods and services became more pronounced. Global supply-chain frictions, logistical bottlenecks for certain components, and concentrated supplier markets still influence price formation for selected durable and specialty goods. Those dynamics, combined with tariffs, contributed to the modest but visible upward pressure on core goods prices in July.

However, the larger and more persistent story is the divergence: goods inflation has been more responsive to global disinflationary forces, while services — mostly domestic — have shown stickiness. Central banks worry about services because they reflect domestic labor and rental markets; cooling goods prices driven by global inputs is less relevant for long-term inflation expectations than sustained services inflation.

For policymakers, the July reading tightens the trade-offs. The Federal Reserve has signalled concern about both inflation and labor-market strength; an uptick in core PCE brings inflation back into sharper focus and could delay or temper the scale of interest-rate cuts that markets had been pricing in. At the same time, if jobs data continue to weaken, that could tilt the Fed toward easing — but only if services inflation decelerates as well.

Key indicators to monitor in the coming months include: wage growth trends in services sectors, shelter metrics (rent prints and owner-equivalent rent), the extent of tariff pass-through observed in producer-level prices, and consumer spending patterns — especially whether household demand for services cools. Policymakers will also track inflation expectations; if businesses and consumers expect higher long-run inflation, that can entrench price-setting behavior and complicate disinflation efforts.

Who is most affected? Households with tight budgets feel the pressure most immediately, as services and housing compose a large share of their spending. Small businesses that operate in service sectors may face squeezed margins if wage costs rise faster than they can increase prices. Conversely, savers and fixed-income investors worry about the real value of returns when inflation sits above target for longer.

In sum, July’s 2.9% core PCE reading reflects the intersection of policy-driven import cost pressures, sticky services inflation rooted in housing and labor costs, and resilient consumer demand. Whether this is a temporary blip or the start of a more persistent trend will depend on the interplay of wage dynamics, tariff effects, and shifting consumer behavior in the months ahead — variables that will shape both market expectations and the Fed’s policy path.

(Adapted from USNews.com)