The market just wrapped up a week where the hotter-than-expected inflation figures barely raised eyebrows, yet a few economists caution that there’s more to the story than investors might be acknowledging.
In July, the producer price index (PPI) hit three-year peaks, largely fueled by inflation in the services sector. A similar pattern was evident in the recent Consumer Price Index (CPI) report earlier this week. This was quite the unexpected turnaround from the previous easing, which had somewhat mitigated the impact of rising commodity costs due to tariffs, as seen in service areas like dental care and airline tickets.
Fresh data puts the Federal Reserve in a tricky spot, as they aim for a 2% inflation target amidst rising price stability pressures and the challenges of achieving maximum employment.
A significant downward revision of last week’s employment numbers has sparked worries that the labor market might be overheating, reinforcing arguments for potential interest rate cuts. However, the recent inflation data could indicate a need for more caution.
As of Friday afternoon, market participants were pricing in about an 85% chance that the central bank would lower interest rates in September. Insights from Federal Reserve Chair Jerome Powell’s upcoming speech at Jackson Hole could provide clues about the Fed’s next policy steps.
Some economists suggest that the Fed should reconsider rate cuts altogether.
“There are widespread inflationary pressures,” said Lauren Saidel-Baker, an economist at ITR Economics, after this week’s unexpectedly high PPI figures. “There are, I think, more reasons for why prices are increasing, and we need to be cautious to prevent inflation from spiraling out of control.”
Saidel-Baker pointed out that these pressures have been building for years, not just due to tariffs. She highlighted rising wages and energy costs as significant contributors currently reflected in the data. She also noted that the full consequences of the tariffs will take time to manifest.
“Inflation is looming closer to us, and it’s a bigger concern than the labor market,” Saidel-Baker emphasized, acknowledging that Fed officials are likely aware of this.
Chicago Federal President Austan Goolsbee warned on Wednesday about the persistent rise in service prices similar to those reported in this week’s CPI data.
“Services aren’t linked to tariffs,” he explained. “It seems like everyone wants to dismiss this as a temporary blip. There is noise in the data. If these trends suggest that the effects of tariffs are becoming less relevant, it raises concern.”
Meanwhile, the latest data paints a complex picture. Michael Gapen, Morgan Stanley’s head of US Economics, shared earlier this week that the July CPI report revealed both positive and negative outcomes.
“The positive takeaway is that the inflationary impact from tariffs wasn’t as significant this month as anticipated,” he noted. “But the drawback is that service inflation has remained quite weak for several months, which has surprised many. Yes, the softness in services might allow us to overlook tariff inflation but some signs are now pointing in the opposite direction.”
“I wouldn’t say that ‘services are ready for a stronger rebound’, but if things start heating up, we’ll need to tread carefully,” he added.
Despite ongoing discussions, Gapen still hopes for interest rate cuts this year, even with the market largely expecting at least one cut.
“There are significant inflationary indications suggesting that we might deviate from the Fed’s objectives,” he observed. “Also, the current immigration policies are likely keeping unemployment low, which creates pressure on the labor market.”
Despite revisions showing a downward trend, the labor market appears robust, supporting consumer spending patterns. Still, there’s a divide as payroll growth slows, job openings decrease, and the number of Americans reliant on ongoing unemployment benefits rises.
Chris Watling, a global economist and chief market strategist at Longview Economics, believes that while inflation may remain steady in the coming months, the more pressing issue is the risk of an economic downturn.
“The crucial factor here is the requirement to employ and expand. And it seems the market’s focus is shifting,” he said. “Manufacturing has stagnated for three years, and the housing sector is declining. I find it astonishing that the Fed isn’t addressing this.”
Watling suggested that the Fed should start easing in September and continue through the year, asserting that the slowdown in core growth may soon surpass inflation levels.
