Early Wednesday morning, the U.S. Commerce Department released the latest inflation figures.
The inflation rate, as measured by the PCE price index, rose 3.7% year-on-year in July, exactly the same as in June. This marks its 65th consecutive month above the Federal Reserve's 2% target. Second-quarter GDP grew at an annualized rate of 1.5%, identical to the initial estimate from last month and slower than the first quarter's 2.1%. Meanwhile, after adjusting for inflation, consumer spending in July did not increase at all.
The New York Times summarized the report in one sentence: America's stubborn inflation problem did not get worse in July, but it did not get better either. The issue is that in the current atmosphere within the Federal Reserve, "not getting better" is itself an answer.
Why Does "Unchanged" Raise Rate Hike Odds?
Because economists expected it to fall. A Reuters survey predicted 3.6%, while the actual figure came out at 3.7%. The month-on-month figure also exceeded expectations, with overall prices rising 0.2% (expected 0.1%), compared to a 0.1% decline in June, which had been the weakest month since April 2020. Core PCE (excluding volatile food and energy) rose 3.3% year-on-year, again identical to June, with the month-on-month rate increasing from 0.1% to 0.2%.
Upon the data release, fed funds futures showed the probability of a September rate hike jumped from about 36% to around 44%. Traders have fully priced in one rate hike by the end of the year.
Omair Sharif, founder of the forecasting firm Inflation Insights, gave the shortest possible assessment: "This is a rate-hike supportive report."
Heather Long, Chief Economist at Navy Federal Credit Union, was more comprehensive: "The United States still has an inflation problem. The latest data gives (Warsh) time to wait and see, but he must be clearer about what he's watching closely and what circumstances would lead him to hike."
The dollar hit its biggest gain in nearly four weeks that day, recouping roughly half of the losses incurred after Treasury Secretary Besant intervened to support the bond market last week. The Bloomberg Dollar Spot Index rose as much as 0.3%, while the yen fell 0.2% to 159.45.
How Did Rate Hike Probability Get Here?
PCE peaked at 7.2% in June 2022, and the steepest round of rate hikes since the 1980s subsequently pulled it back onto a path toward 2%. That path was interrupted last year. A round of import tariffs following Trump's return to the White House pushed up prices for a wide range of goods.
In late February this year, the U.S. and Israel took action against Iran. Before the war started, PCE was 2.9%. The conflict shut down roughly one-fifth of global oil supply, sending energy prices spiraling upward and pushing PCE to a three-year high of 4.1% in May.
Six months on, a final resolution to the conflict remains distant, but the intensity of fighting has decreased, and oil prices along with the wave of inflation they fueled have receded from their late-spring highs.
They receded to 3.7%, and then stalled there.
The trouble is, new tariff pressures are on the way: Last Friday, U.S. negotiations with its second-largest trading partner, Canada, broke down. New tariffs on $20 billion worth of Canadian goods have taken effect, and both sides have since announced additional retaliatory measures set to take effect in the coming months.
The nuance of this report is that both the camp advocating for patience and the camp advocating for a rate hike can find ammunition in it.
The camp advocating for patience sees that: inflation did not worsen; high oil prices, aside from specific categories like airfare, have barely spread throughout the broader economy; and starting next month, the Bureau of Economic Analysis will change how it calculates prices for a subset of services (portfolio management services, software, and computer accessories) – an adjustment that is likely to lower measured inflation.
The camp advocating for a rate hike sees that: both headline and core inflation in July were hotter than forecasters expected; service prices excluding housing (an indicator some officials view as a gauge of underlying price pressure) rose faster than in June; diesel prices are near record highs, which will push up the cost of far more than one category of goods; the AI boom is pushing up chip prices; and the trade war with Canada has just reignited.
And the most fundamental argument has nothing to do with the monthly data: inflation has been above target for over five years. The argument from this camp is that the central bank must act decisively, or risk losing credibility.
But in reality, the economy is cooling. This is the most easily overlooked, and most critical, half of the report.
In July, inflation-adjusted consumer spending saw zero growth, after posting strong gains in the previous two months. In nominal terms, personal income rose 0.4% and consumer spending rose 0.2%, both exceeding expectations; but after subtracting inflation, real growth was zero.
Even more telling is income: compared to a year ago, inflation-adjusted income rose only 0.2%, and it had been negative for many months prior.
In other words, even as the inflation rate number is coming down, five years of cumulative price increases have eroded incomes. This explains why in consumer confidence surveys, most Americans remain pessimistic about the economy and their own financial situation.
What Will Warsh Say on Friday?
Second-quarter GDP at 1.5% sounds mediocre. But the underlying structure is nothing like that.
Consumer spending, which accounts for over two-thirds of U.S. economic activity, grew at an annualized rate of 3.4%, revised up from the initial estimate of 3.2%; in the first quarter, this figure was only 0.5%. Business investment excluding residential structures grew 8.5%, reflecting the heat of AI investment. And a specific measure of the economy's intrinsic strength – final sales to private domestic purchasers, which strips out volatile government spending and trade – grew 4.2%, the strongest in over three years, revised up from the initial 3.9%; in the first quarter, it was 1.7%.
Housing investment also rose, for the first time since late 2024.
So what dragged the 1.5% figure down? Imports.
Imports surged at a 12.5% annualized rate in the second quarter, with a significant chunk being computer chips and related products supporting AI investment. GDP only counts domestic production, and imports are subtracted – this single item alone knocked off 1.64 percentage points. Government spending fell 1%, with non-defense outlays pulling back sharply, also acting as a drag.
Thus, a strange picture emerges: chips bought to build AI are depressing this country's growth number.
The second-quarter GDP will have a third and final revision, to be released on September 30th.
The landing point for all this data is the podium at Jackson Hole this Friday.
Federal Reserve Chairman Kevin Warsh will deliver his first major speech since taking office. He has promised to end above-target inflation but has yet to give any hint as to whether he believes inflation can subside on its own without a rate hike. Wednesday's data did not show that it can.
The policy rate has been parked in the 3.5% to 3.75% range since last December. At the July meeting, three officials voted against, advocating for a 25 basis point rate hike.
Bank of America FX strategist Alex Cohen highlighted the uncertainty surrounding the speech: "There is clear two-way risk around Warsh's Jackson Hole speech. It remains a wild card."
And beyond all this, there is another timeline: the midterm elections are 10 weeks away. Gasoline prices remain high due to the war with Iran, the president is threatening new tariffs on Canada and China, and AI infrastructure spending is pushing up prices for computers, gaming consoles, and semiconductors.
Prices are becoming a core issue in this election.
