On Wednesday morning, the U.S. Department of Commerce released the latest inflation figures.
The inflation rate, as measured by the July PCE price index, rose 3.7% year-over-year, unchanged from June. This marks the 65th consecutive month above the Federal Reserve’s 2% target. Economic growth slowed in the second quarter, with GDP at an annualized rate of 1.5%, matching the initial estimate from last month and down from 2.1% in the first quarter. Meanwhile, after adjusting for inflation, consumer spending in July showed no increase.
The New York Times summed up this report in one sentence: Stubborn U.S. inflation did not get worse or better in July. The problem is that, under the current atmosphere at the Federal Reserve, “not getting better” is itself an answer.
Why does "holding steady" actually increase the probability of a rate hike?
Economists had expected a decline. The Reuters survey forecast was 3.6%, but the actual figure came in at 3.7%. The month-over-month increase also exceeded expectations, rising 0.2% (vs. the expected 0.1%), compared to a 0.1% drop in June, which had been the weakest month since April 2020. Core PCE (excluding volatile food and energy) rose 3.3% year-over-year, unchanged from June, and the month-over-month increase climbed from 0.1% to 0.2%.
Upon the data release, federal funds futures showed the probability of a September rate hike jumping from around 36% to approximately 44%, and traders have fully priced in at least one rate hike before year-end.
Omair Sharif, founder of forecasting firm Inflation Insights, offered the shortest comment: "This is data that supports rate hikes."
Heather Long, Chief Economist at Navy Federal Credit Union, put it more plainly: “The U.S. still has an inflation problem. The latest data gave (Waugh) time to wait, but he must be clearer about what he’s closely monitoring and what conditions would prompt him to raise rates.”
The dollar posted its largest gain in nearly four weeks, recouping about half of last week’s losses following Treasury Secretary Bessent’s intervention in the bond market. The Bloomberg Dollar Spot Index rose as much as 0.3%, while the yen fell 0.2% to 159.45.
How did the probability of an interest rate hike get here?
PCE peaked at 7.2% in June 2022, and the steepest round of rate hikes since the 1980s brought it back on track toward 2%. That trajectory was disrupted last year, as a new round of import tariffs following Trump’s return to the White House pushed up prices for a wide range of goods.
At the end of February this year, the United States and Israel launched strikes against Iran. Before the conflict began, the PCE was 2.9%. The conflict shut down about one-fifth of global oil supply, causing energy prices to spiral upward, and the PCE surged to a three-year high of 4.1% in May.
Six months have passed, and the conflict remains far from resolution, but the intensity of fighting has decreased, and oil prices, along with the inflation they triggered, have retreated from their spring peak.
Drop to 3.7%, then stop there.
The problem is that new tariff pressures are on the way: Last Friday, negotiations between the United States and its second-largest trading partner, Canada, broke down, and new tariffs on $20 billion worth of Canadian goods have already taken effect; since then, both sides have announced additional retaliatory measures that will come into force over the coming months.
The subtlety of this report is that both those advocating for waiting and those advocating for rate hikes can find ammunition within it.
Those advocating for waiting observe that inflation has not worsened; high oil prices have hardly spread throughout the economy beyond a few specific categories like airfare; and starting next month, the U.S. Bureau of Economic Analysis will change its methodology for calculating prices of certain services (portfolio management services, software, and computer accessories)—a change that is likely to lower the measured inflation rate.
The group advocating for rate hikes points to: both overall and core inflation being hotter than expected in July; prices for services excluding housing—which some officials view as a key indicator of underlying price pressures—rising faster than in June; diesel prices nearing record highs, pushing up more than just one category of goods; the AI boom driving up chip prices; and the trade war with Canada having just been reignited.
And the most fundamental argument has nothing to do with this month’s data: inflation has been above target for more than five years. This school of thought argues that the central bank must act decisively, or it will lose credibility.
But in reality, the economy is cooling down. This is the half of the report that is easiest to overlook—and the most critical.
In July, inflation-adjusted consumer spending registered zero growth, after strong increases in the previous two months. Nominal personal income rose 0.4% and consumer spending increased 0.2%, both above expectations; however, after accounting for inflation, real growth amounted to zero.
More telling is the income: adjusted for inflation, income rose only 0.2% compared to a year ago, after being negative for several months prior.
In other words, even though the inflation rate has come down, the cumulative price increases over five years have eroded incomes. This explains why, in consumer confidence surveys, most Americans remain pessimistic about the economy and their personal financial situations.
What will Wash say on Friday?
Q2 GDP at 1.5% sounds unremarkable, but the underlying structure tells a completely different story.
Consumer spending, which accounts for more than two-thirds of U.S. economic activity, rose at an annualized rate of 3.4%, upwardly revised from the initial estimate of 3.2%; it was only 0.5% in the first quarter. Business investment excluding housing increased by 8.5%, reflecting the surge in AI-related investments. Meanwhile, a measure of underlying economic strength—final sales to private domestic purchasers, which excludes volatile government spending and trade—grew by 4.2%, the strongest in over three years, upwardly revised from the initial reading of 3.9%; it was 1.7% in the first quarter.
Housing investment also rose, the first time since the end of 2024.
What brought down the 1.5%? Imports.
Imports surged at a 12.5% annualized rate in the second quarter, with a significant portion consisting of computer chips and related products supporting AI investments. Since GDP only counts domestic production, imports are subtracted—this item alone reduced GDP by 1.64 percentage points. Government spending fell 1%, and non-defense spending dropped sharply, further weighing on growth.
Thus, a strange situation emerged: chips purchased to build AI suppressed the country's growth figures.
The second-quarter GDP will undergo a third and final revision, to be released on September 30.
All of this data leads to the podium at Jackson Hole this Friday.
Federal Reserve Chair Kevin Warsh will deliver his first major speech since taking office. He has pledged to end inflation above target, but has yet to indicate whether he believes inflation can subside on its own without rate hikes. Wednesday’s data showed no sign that it can.
The policy rate has remained in the range of 3.5% to 3.75% since December last year. At the July meeting, three officials voted against maintaining the rate and advocated for a 25-basis-point hike.
Bank of America foreign exchange strategist Alex Cohen warned of the uncertainty surrounding the speech: "Wash's Jackson Hole speech carries clear two-way risks and remains an unknown factor."
Beyond all of this, there is a timeline: 10 weeks remain until the midterm elections. Gas prices remain high due to the war in Iran, the president is threatening new tariffs on Canada and China, and spending on AI infrastructure has driven up prices for computers, gaming consoles, and semiconductors.
Prices are becoming the central issue in this election.
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