Core inflation came in at 0.2% month-over-month in July, matching the slowest annual pace since March 2021 at 2.5%. That's two consecutive months of subdued readings, and the Fed's got about five weeks to figure out whether they're hiking rates again or sitting tight.
The headline number was even softer. Overall CPI rose just 0.1% from June and 3.4% year-over-year. Energy prices dropped for the second straight month, and grocery prices actually declined for the first time since March. Lettuce prices fell hard thanks to the cyclospora outbreak, and uncooked ground beef dropped 1.6%, the biggest decline since 2020.
This is the kind of inflation report that makes the Fed's job harder, not easier. Not because the numbers are bad, but because they're ambiguous. Inflation's cooling, but the labor market's also showing cracks. July payrolls declined. Real wages dropped 0.2% year-over-year. So what do you prioritize? Fighting inflation that's already decelerating, or avoiding a slowdown that's already started?
Where the Pressure Points Are
Shelter costs rose just 0.1% in July, restrained by a 3.3% drop in hotel and motel rates, the biggest decline in over a year. But the Fed watches rent measures closely, and both of those ticked up 0.3%. That's not a lot, but it's not zero either.
Services prices, excluding energy and rents, rose 0.2% after declining the month before. Medical care and airfares both saw increases. Goods prices, excluding food and energy, rebounded after two months of declines. Computer software and accessories jumped 21.2% year-over-year, a record, driven by the global memory chip shortage as companies race to build data centers.
If you've been following the Apple Mac and iPad price hikes from June, that's starting to show up in the data. Computers, peripherals, and smart home assistants all posted their biggest gains in over four years. Tech inflation is real right now, even as headline inflation cools.
What the Fed's Actually Looking At
The September 15-16 meeting is five weeks out, and the Fed's going to see more employment and inflation data before then. Producer prices drop Thursday, which'll give more insight into categories that feed directly into the PCE index, the Fed's preferred inflation gauge. Core PCE has been running hotter than core CPI this year, so Thursday's PPI matters.
Chairman Kevin Warsh is expected to speak at Jackson Hole later this month, and everyone's going to parse every word for clues about September. "It's good news for those Fed officials who want to be patient here," said Oscar Munoz from TD Securities. "At least for the Fed officials who are looking for signs of progress, disinflation, it's a second consecutive report."
That's the key phrase. Second consecutive report. One month of cooling inflation is noise. Two months is a data point. The question is whether two months is enough to justify holding rates when the labor market's weakening at the same time.
US stocks opened higher after the report, and Treasury yields fell as investors pared bets on a September hike. The market's reading this as dovish. But the market's been wrong before, and the Fed doesn't always move in sync with what bond traders want.
The Energy Wildcard
Gasoline prices are the wildcard nobody's talking about enough. US gas prices pushed above $4 a gallon again in July after the US-Iran ceasefire collapsed and hostilities reignited. But the average for the entire month was still lower than June, which is why energy prices declined overall.
That ceasefire situation is unstable. If hostilities escalate again, energy prices spike, and the Fed's looking at a different inflation picture in August and September. Geopolitics don't care about your rate decision timeline.
The Iran situation matters because energy price shocks don't just hit the headline CPI number. They ripple through the entire economy. Transportation costs rise, which pushes up the cost of moving goods, which eventually shows up in services inflation. The Fed knows this, which is why they're watching the Middle East as closely as they're watching the jobs data.
What Could Go Wrong
The biggest risk is that the Fed hikes in September based on lagging data and ends up overtightening into a slowdown that's already underway. Real wages are down year-over-year. Payrolls declined in July. Core inflation's at a five-year low. "It's hard to make an urgent case to hike," according to the Bloomberg quote in the original report.
But the Fed doesn't always move on what's urgent. They move on what's durable. If they think inflation's going to resurge in Q4, they'll hike now to get ahead of it, even if the current data says pause. That's the calculus.
The second risk is the PCE revision. In September, the Bureau of Economic Analysis is changing how prices are calculated for legal services, computer software, and investment advice in the PCE index. Methodological changes can shift the data in ways that aren't immediately obvious, and the Fed could end up reacting to a number that's been revised under the hood.
The September Setup
Here's what we know going into the Fed's September meeting. Core CPI is decelerating. The labor market's weakening. Energy prices are volatile and geopolitically driven. Services inflation is sticky but not accelerating. Goods inflation is rebounding in tech categories.
The Fed's got two conflicting signals. Inflation's cooling, which argues for patience. But the labor market's softening, which argues for cutting, not hiking. The data between now and September 15 is going to matter a lot, especially Thursday's PPI and whatever comes out of Jackson Hole.
If you're trading indices or rate-sensitive sectors, the setup is binary. Either the Fed pauses and risk assets rally, or they hike and you get a repricing lower. The July CPI report tilts the probability toward a pause, but it doesn't lock it in. Watch the next payrolls number and watch what Warsh says at Jackson Hole. Those are the two data points that'll tip the decision one way or the other.
