Inflation’s latest readings are stirring the pot for the Federal Reserve, and investors need to pay close attention. July’s Consumer Price Index (CPI) data revealed that tariffs are quietly nudging goods prices higher, complicating the Fed’s decision on whether to hold interest rates steady or cut them soon. But there’s more beneath the surface—here’s what savvy investors should know and how to position themselves.
Inflation: A Mixed Signal with Tariff Undertones
July’s CPI rose 3.1% year-over-year excluding food and energy, slightly hotter than the 3% consensus and up from June’s 2.9%. Month-over-month, prices increased by 0.3%, aligning with expectations. Interestingly, headline CPI came in a bit cooler than forecast at 2.7% versus 2.8%. This divergence points to a nuanced inflation environment where tariffs are influencing goods prices but the broader inflation picture is shaped heavily by services.
Stephen Brown, deputy chief North America economist at Capital Economics, highlights the “narrative shift” for the Fed: tariffs are barely perceptible now, but services inflation is picking up. Services inflation is notoriously sticky and harder to tame, often signaling deeper inflationary pressures. This means the Fed’s inflation target of 2% remains elusive, with current inflation more than a full percentage point above target.
The Fed’s Dilemma: To Cut or Not to Cut?
Fed Chair Jerome Powell has been cautious, wanting to observe tariff impacts over the summer months before making policy moves. While some goods like furniture and shoes saw price upticks, the data didn’t conclusively show tariffs causing persistent inflation. Yet, the labor market is sending a different signal.
July’s jobs report showed only 73,000 new jobs added, with unemployment ticking up to 4.2%. More concerning are the downward revisions to May and June’s job gains—from over 140,000 each month to under 20,000 and 14,000 respectively. The three-month average of 35,000 jobs is a stark slowdown, suggesting hiring is stalling even as the population grows. This labor softness is making some Fed officials nervous.
San Francisco Fed President Mary Daly warned that a weakening labor market could trigger rapid declines and called additional slowing “unwelcome.” Fed Governor Michelle Bowman echoed this, signaling three potential rate cuts this year to avoid further economic slowdown. On the flip side, Atlanta Fed President Raphael Bostic and Cleveland Fed President Beth Hammack remain more focused on inflation risks, advocating a cautious approach with fewer cuts.
What This Means for Investors
Markets are pricing in a 90% chance of a 25 basis point rate cut in September, reflecting the Fed’s internal tug-of-war. For investors, this creates both risks and opportunities:
- Fixed Income: A rate cut could push bond prices higher, but the inflation backdrop means investors should favor shorter-duration bonds to reduce interest rate risk. Inflation-protected securities (TIPS) remain a smart hedge.
- Equities: Rate cuts typically buoy stocks, especially rate-sensitive sectors like real estate and utilities. However, the mixed signals from inflation and labor markets suggest selective stock picking is crucial. Focus on companies with pricing power that can pass on higher costs to consumers.
- Commodities: Tariffs are keeping goods prices elevated, benefiting commodity producers. Consider exposure to sectors like metals and agriculture, which may see sustained demand amid inflationary pressures.
Unique Insight: Watch the “Tariff Pass-Through” Effect
A rarely discussed angle is the “tariff pass-through” effect—how much of the tariff cost is actually passed to consumers versus absorbed by companies. Recent data from the National Bureau of Economic Research shows that in some sectors, companies are absorbing over 40% of tariff costs to maintain market share, which could delay inflation but squeeze corporate margins. Investors should monitor corporate earnings reports closely for margin compression, especially in retail and manufacturing.
What’s Next?
The Fed’s September meeting is shaping up to be a pivotal moment. If labor market weakness continues, expect rate cuts to begin, but don’t anticipate aggressive easing given persistent inflation. The balance the Fed seeks between supporting growth and taming inflation will keep markets volatile.
For advisors and investors, the key takeaway is to remain flexible and diversified. Inflation is not going away overnight, and the labor market’s health will heavily influence Fed policy. Stay informed on tariff developments and sector-specific impacts, and consider inflation-hedged assets as part of your portfolio strategy.
Sources:
- Capital Economics
- National Bureau of Economic Research
- Federal Reserve official statements
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Source: New inflation reading creates dilemma for Fed over cutting rates in September