Here is the number that caught our eye this week. The personal consumption expenditure measure of inflation, which is the gauge the Federal Reserve officially targets, is running at a little over 4 percent year over year as of May. On a single-month basis, the pace is even hotter, at about 5.5 percent annualized. The Fed’s policy rate sits at 3.75 percent. That means the central bank is, right now, charging less to borrow than the rate at which prices are rising. In plain terms: money is still cheap relative to inflation.

That alone would be worth a conversation. But pair it with this: the two-year Treasury note, which reflects what markets expect the Fed to do over the next couple of years, sits at 4.13 percent. The market is already priced above the Fed. The bond market is quietly telling you that either inflation stays sticky and rates stay higher for longer, or the Fed eventually has to follow. That gap between where the Fed is and where markets are pricing is the tension worth watching right now.

We are not in a crisis. We want to be clear about that. The overall picture still reads as risk-on, with meaningful momentum behind it. But the ingredients for a policy surprise are present, and that is exactly what a business owner or capital allocator should be thinking about.

What is actually driving this

The inflation story is not simple. Shelter costs, measured in the consumer price index, are running at about 3.6 percent year over year. Services are close behind at about 3.6 percent as well. Goods, which in past cycles provided deflationary relief, are only contributing about 1 percent of downward pressure. That cushion is largely gone.

The bigger force here is the investment boom itself. Capital goods orders have surged. Defense spending is elevated. The artificial intelligence infrastructure buildout is consuming enormous amounts of physical equipment, energy, and skilled labor. That spending is income-generating and economically valuable, but it does not produce consumer goods. When you pour money into building capacity rather than filling shelves, you get demand without immediate supply relief. That is inherently inflationary in the short run.

On top of that, consumers have been drawing down savings and tapping assets to keep spending going. The household savings rate is at 2.6 percent. That is thin. Real spending has been outpacing real income growth, which is not sustainable indefinitely. So you have an economy that is running on a combination of investment momentum, thin consumer buffers, and a Fed that has not yet had a compelling reason to tighten further.

The war in the Middle East added an energy price shock that pushed inflation higher through the spring. Crude oil prices have since come back down, and some relief may flow through to consumers in the months ahead. But the base effects from late 2024 and early 2025 are still working their way through the annual numbers, and meaningful year-over-year improvement may not show up until early 2027.