Inflation Is Sending Its Scariest Warning in 3 Years

Inflation is proving harder to defeat than the Federal Reserve hoped. After two years of progress bringing price increases down from their pandemic-era peaks, inflation is climbing again. The latest government figures show prices rising 3.6% annually, nearly twice the Fed’s 2% target. Meanwhile, wholesale inflation is running even hotter, threatening to push additional costs onto consumers.

Yet there’s something more troubling brewing beneath those headline numbers. A little-followed Federal Reserve inflation indicator has reached a level not seen in three years, suggesting America’s inflation problem could be becoming harder to solve.

A 3-Year Inflation Warning Flashes Red

The Federal Reserve Bank of San Francisco tracks inflation differently from the government’s traditional Consumer Price Index (CPI). Instead of simply measuring how much prices have risen, it attempts to determine why they’re rising.

Its Supply- and Demand-Driven PCE Inflation report separates price increases into three categories: supply-driven, demand-driven, and those that cannot be clearly attributed to either.

The latest analysis of August’s data reveals something unsettling: Demand-driven inflation contributed approximately 1.2 percentage points to the annual inflation rate, its highest contribution since September 2023. That compares with roughly 0.8 percentage points in early 2025.

The breakdown looks like this:

Demand-driven inflation accounts for approximately 35% of the total, making it the largest identifiable source of price pressure. That’s the warning investors shouldn’t ignore.

Why This Inflation Is More Dangerous

Inflation caused by supply disruptions can eventually ease as production recovers, shipping routes reopen, or energy supplies improve. But demand-driven inflation presents a different problem.

When consumers and businesses keep spending, companies have more room to raise prices without losing customers. That pricing power can persist even after supply disruptions disappear.

The San Francisco Fed identifies demand-driven inflation when unexpected changes in prices and purchasing quantities move together. It’s a statistical estimate rather than a direct measurement of consumer behavior, but the direction of the trend deserves attention.

The Bureau of Economic Analysis reported Oct. 29 that September’s personal consumption expenditures (PCE) price index rose 0.5% for the month and 3.6% annually, accelerating from August’s 3.4%.

Consumers increased nominal spending 0.5%, but after adjusting for inflation, purchases were essentially unchanged. Disposable income actually fell 0.3% in real terms. Meanwhile, diesel producer prices have climbed 115% annually, creating another potential source of higher transportation and merchandise costs.

In other words, households are spending more money without necessarily getting more goods and services.

Granted, demand-driven inflation remains well below its 2022 and 2023 peaks. The latest figures thankfully don’t signal another inflation crisis on that scale. But they suggest inflation isn’t simply a temporary supply problem that will disappear on its own.

The Federal Reserve Has a Bigger Problem

The Fed’s traditional answer to stubborn demand-driven inflation is higher interest rates. More expensive mortgages, car loans, and business financing discourage borrowing and spending. Eventually, weaker demand can reduce companies’ ability to increase prices.

Unfortunately, that medicine also carries risks for the economy and stock market.

The Fed held its benchmark interest rate at 3.75% to 4.00% yesterday. With inflation still running above target, policymakers face mounting pressure to keep borrowing costs elevated, or potentially raise them again.

For investors, that challenges stock valuations built around expectations of cheaper money. Growth stocks are particularly sensitive because higher interest rates reduce the present value investors assign to their future earnings. Companies with heavy borrowing requirements face higher financing costs, too.

Conversely, profitable businesses with manageable debt, reliable cash flow, and the ability to pass along higher costs should be better positioned.

Key Takeaway

In short, inflation’s latest warning isn’t simply that prices are rising again. It’s that underlying demand is contributing more to those increases than at any point in three years. That could make returning inflation to 2% more difficult, even if energy prices eventually retreat.

Investors shouldn’t interpret one reading as proof another inflation surge is inevitable. But neither should they build portfolios assuming interest rate cuts are just around the corner.

For now, favor financially strong companies with proven pricing power, avoid excessive debt, and maintain a diversified portfolio that can withstand interest rates remaining elevated longer than expected.

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