Kiplinger Inflation Outlook: The Fed’s Quandary

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A slight pickup in services inflation (excluding energy) in the July Consumer Price Index report is worrisome, but could be just a blip. In July, dental services jumped 2.6% and airfares 4.0%, but these large jumps are not likely to be repeated. There may actually be some easing of these costs in the August report. However, car repair rose 0.8% in July - the latest in a long series of increases, which has pushed repair prices up 11.0% over the past year.

Tariffs pushed up prices of some goods in July’s inflation report, but so far have had only a modest effect on overall inflation. Prices of some consumer goods that are typically imported are rising strongly, such as cookware/tableware (up 6.9% over the past year), window and floor coverings (up 7.2%), audio equipment (up 12.4%), tools (up 4.7%) and basic furniture (up 7.6%). However, other categories that include a lot of imports have not shown a price bump yet, such as motor vehicles and televisions. It seems likely that tariff costs will become more noticeable in prices as pre-tariff inventories of imported goods are drawn down throughout the summer. However, some businesses may opt to cut their profit margins rather than lose market share.

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The price increases from tariffs have not been enough, yet, to push the yearly inflation rate upward very much. Overall annual inflation stayed at 2.7%, the same rate as in June, but the core inflation rate (which excludes food and energy) picked up to 3.1% from 2.9%. The cost of groceries and energy declined a bit. One piece of good news for consumers is that egg prices dropped 3.9% in July, their fourth consecutive decline, and are 19.9% lower than their February peak.

The uncertainty about the impact of tariffs on prices and the modest rise in services inflation could keep the Federal Reserve on hold at its next policy meeting on September 17. The Fed would like to see whether the bump in services prices in July comes down in August and also study the effects of tariffs on inflation over the next several months before it cuts its benchmark interest rate. But the labor market is weakening, and financial markets overwhelmingly expect the Fed to cut rates in September. It’s a bit of a coin flip, but if the Fed stands pat in September, then a cut at the next meeting, on October 29, seems almost guaranteed.

While the headlines focus on the Consumer Price Index, note that the Fed’s goal of 2% inflation is based on a different measure called the personal consumption expenditures (PCE) deflator, not the CPI. The PCE deflator excluding food and energy is forecast to have risen at a 2.9% rate for the 12 months ending in July, compared with the core CPI’s 3.1% number. That’s still well above the Fed’s target for 2% inflation over the long term

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