Softer US inflation eases rate hike pressure

US Consumer Price Index (CPI) inflation eased more than expected in June, reducing the probability of a hike at the Federal Open Market Committee (FOMC) meeting later this month. The improvement was not just energy related; it also included a broad based easing across a number of segments in core inflation too.

Headline inflation fell 0.4% month-over-month in June, lower than the -0.1% expected, taking the year-over-year rate from 4.2% to 3.5%. More important for the Federal Reserve (Fed), however, was the improvement in underlying inflation, with core CPI printing at -0.02% (vs 0.2% expected) in the lowest monthly print since May 2020. While fears of a broadening in inflationary pressures in the US had recently increased, there wasn't much evidence of that in this report, with both core goods and core services printing on the softer side versus expectations. 

The fears had been eloquently defined by Christopher Waller (a Fed governor) in a speech at the New York Association for Business Economics on Monday. The tone was definitely on the hawkish end of the spectrum, but we also noted that he highlighted the fact that "there's a credible case for inflation to begin to fall back to our 2% goal with policy at its current setting”. Waller, who has a track record of being a leading indicator for the Fed in recent years, highlighted that 2026 is different to 2022, namely due to a labour market that is not as tight as three years ago and the fact that inflation expectations have remained well anchored and close to target across the breakeven curve. 

But well anchored inflation expectations do not mean the Fed should not respond to inflation that remains persistently above target. As Waller puts it, "sternly staring at inflation until it melts before our withering gaze is not an option". While energy has been the primary driver of monthly increases in inflation in recent months, the increases in core did not start in March. Core personal consumption expenditures (PCE), one of the Fed's preferred measures of underlying inflation, was not showing signs of decisively declining towards the 2% target before the Iran war started and is around 80 basis points (bp) off the April 2025 lows at 3.4%, with the largest monthly prints this year coming in January and February (to be fair, the start of the year is seasonally stronger).

Alongside energy, the two key drivers of this have been tariffs and spillovers from the artificial intelligence (AI)build out, with sharp increases in the prices of memory and semiconductors likely to feed through to consumer goods in the coming months. While there is some evidence of computer software and price increases in last month’s numbers, the tariff impact seems to have largely dissipated. 

The market response was as expected, with the two-year yield falling by 8bp to 4.18% (roughly in line with where it started the year) while the probability of a hike at the July FOMC meeting fell from 40% to 16%.  The market is pricing in just over one hike this year from the Fed at the December meeting. While we think the most likely scenario is that they stand pat, we also think the hurdle for a hike is low if the monthly core prints pick up.

A final point we would make is the contrast in inflation dynamics between the US and Europe. The tariff and AI impact in Europe, while not non-existent, is lower. The movements in energy prices and their impact on inflation expectations will determine the path of rates in the coming quarters, and if an expected deal between the US and Iran materialises, we wouldn't expect the European Central Bank (ECB) to hike – noting that the central bank has already acted early, with its 25bp hike in June. Growth in Europe is weaker than in the US, with Bloomberg consensus estimates of 0.5% in line with the ECB's severe scenario estimates in its June staff macroeconomic projections (which had oil peaking at $166 per barrel in the third quarter). We think, therefore, the risk of second round effects is low, and wage growth, like in the US, continues to be at a level that is consistent with core inflation at 2%. 

Ultimately, in both cases, we have central banks that will be willing to act quickly if the data deteriorates. The anchoring of inflation expectations points to this policy credibility, reaffirmed by Kevin Warsh (chair of the Fed) in his testimony given to Congress yesterday. While in the base case we view hikes as unnecessary, if we do get them, we expect them to be small mid cycle adjustments rather than the start of a hiking cycle. Amongst other things, this means that 25bp hikes in monetary policy rates should not necessarily translate into equivalent moves in the long end of the curve.