US Watch – Hawks under pressure

CPI inflation came in at -0.4% m/m, dropping the y/y rate to 3.5% from 4.2% prior. Core CPI was unchanged, dropping the y/y rate to 2.6%. Both headline and core inflation came in well below the consensus forecasts. Headline was driven down by a 5.7% month over month decline in energy prices, while food inflation remained relatively stable at 0.2% m/m. Across the core basked, prices in almost all major categories declined. This could be due to weak demand, but could also just reflect an overall unwind of energy prices. The decline was spearheaded by apparel and used cars, and we also saw a large decrease in car insurance premiums. Despite demand from the world cup, hotel rates dropped, but we did see AI-driven inflationary pressures with Computer and Software accessories prices rising by 2.3% last month, up a total 17.4% for the year.

What does this pleasant surprise mean for the Fed? The recently released FOMC minutes for the June meeting provided a useful guide to the FOMC’s reasoning. It contained a key paragraph outlining the fact that the FOMC essentially sees two plausible scenarios. The first is one where inflation improves ‘soon’, where they deem it appropriate that rates will be held steady in the near term before eventually being cut. The word ‘soon’ is ill-defined, but it suggests the pace of inflation needs to improve in the coming months. The second scenario is one of sticky inflation (due to e.g. AI-related demand, the energy shock or tariffs) and a stable labour market, which would require ‘some firming’. The source of inflation does not seem to matter, and we see the most likely interpretation of ‘some firming’ as a 25 bps hike in both September and December. The condition of a stable labour market is important. The FOMC agreed on the response to the scenarios but disagreed on the relative likelihood of the two, as was also reflected in the dot plot. Market pricing was consistent with a roughly 20 and 80% probability of the two scenarios before today’s CPI report. They even continued to price in a chance of a July rate hike. After today’s CPI release, this rapidly shifted to a roughly 40 and 60% probability, and July was mostly priced out.

Weighing the two scenarios, we continue to think the former scenario is the more likely. Today we began the descent from peak-hawk. We’ve seen less pass-through of tariffs, the pass-through of the energy shock to core inflation has been limited, and one could hardly describe the labour market as overheating. In fact, we see some risks of potential rapid deterioration if participation bounces back. On the other side of the argument, getting core PCE to even just 3% by year end requires average m/m gains of less than 0.18%, which is substantially below the level we’ve seen in recent months, and also more rapid than our base case. It is not clear whether the majority of the FOMC has that kind of patience after years of above-target inflation. Even Christopher Waller, who dissented against holding rates in favour of cutting last year, argued that another hot reading on core inflation could require tightening monetary policy in the ‘near term’. This month’s reading was not that trigger.

We don’t expect much forward guidance from Chair Warsh’s testimony before the Senate Banking Committee later today, most likely deferring to the ‘we have a task force for that’ mantra for most difficult questions. Tomorrow’s PPI data will complete our PCE nowcast which will be key to whether July hike pricing is further reduced or revived, as the actual formal release is only after the July FOMC meeting. The data flow through the rest of the summer, alongside Iran-related oil price developments, should help determine which of the two scenarios will ultimately prevail. We continue to expect the Fed to remain on hold for the rest of the year.