Key Takeaways After the Best News on Core Inflation in a Long Time

In our latest US economic outlook, we call for inflation to fall over the next few years, clearing the way for Federal Reserve rate cuts in 2027 and 2028. And while we’re always careful not to overinterpret one month’s worth of data, June’s Consumer Price Index report gave more than a glimmer of hope that view is playing out.

June CPI Brings Good News on Inflation

CPI prices fell 0.4% month over month in June. This included a large negative contribution from energy prices (negative 0.4%), as had been known in advance. The surprise came from core prices, which were essentially flat (negative 0.02%) month over month. That’s the lowest month-over-month result since the depths of the pandemic downturn in May 2020.

Core inflation in June was low in almost every major category. Significant items that saw a large drop in prices (greater than 2% month over month) included hotels, motor vehicle insurance, and wireless telephone bills.

The low core inflation came despite not getting any visible pass-through of lower energy prices into core CPI. For instance, airline fares, which are up 27% year over year, increased a further 0.2% month over month in June. Fares should drop back eventually as airlines’ fuel costs recede, weighing on core inflation in coming months.

Based on the CPI data, we expect core personal consumption expenditures to increase 0.1%-0.15% month over month in June. That will put the three-month growth rate at about 2.9% annualized and the year-over-year growth rate at 3.3%.

Although the Fed almost never reacts heavily to a mere one month’s data, the magnitude of this week’s CPI report is likely to tip the Fed decisively against a July rate hike. The market-implied probability of a hike dived to 12% when the CPI data was released on July 14, down from 42% the day before. However, with the year-over-year core PCE inflation rate still well above the Fed’s 2% target, it may take a lot more low inflation readings to sway the Fed away from hiking rates over the next six to 12 months.

What’s Driving Inflation?

Overall PCE inflation will stand at about 3.7% as of June 2026, a huge increase from its 2.6% average in 2025. But that’s driven heavily by oil prices. So long as oil prices recede over the next year (as is currently priced into futures markets), then overall inflation is sure to drop back sharply due to falling energy prices. Admittedly, the disruption to oil supply could be longer than the market thinks, but we do agree that supply will ultimately return.

More worrying from the Fed’s perspective is the rise in core inflation, which began before the oil price shock. Core PCE inflation will likely stand at 3.3% year over year as of June, up from an average 2.8% in 2025.

For a while, the main driver of the uptrend in core inflation had been tariffs, which caused core goods inflation to rise well above its normal rate of about zero growth. That was partially offset by falling housing inflation.

More recently, core services excluding housing have trended up, to around 3.8% year over year as of June from an average 3.3% in 2025. Illustrative components include restaurants, healthcare, and personal services. Core services excluding housing is sometimes dubbed “supercore,” as it’s thought to be particularly tethered to the underlying rate of inflation in the economy. So, its rise is perhaps the most worrying of all, at first glance.

Reasons to Be Sanguine About Inflation

First, year-over-year core PCE inflation will probably be revised down by about 0.2 percentage points once the Bureau of Economic Analysis’ Annual Update is released at the end of September. That update will introduce a better methodology for software inflation, which is currently contributing around 0.2 percentage points to year-over-year core PCE inflation. Fed researchers have argued convincingly that the current software inflation gauge is flawed, and the BEA is fixing it.

Housing inflation should continue its downward trend. Market rents (representing leases signed by new tenants) have exhibited tepid growth for years now, after skyrocketing during the pandemic. The housing component of the main price indexes (CPI and PCE), representing the average rent paid by all tenants, has finally caught up to market rents.

Perhaps the biggest reason we expect inflation to continue to fall is wage growth.

Our composite measure of wage growth stood at 3.5% year over year as of the first quarter of 2026, down markedly from the peak of 6.2% year over year in the first quarter of 2022. Subtracting productivity growth (which has been running at 1.5-2%), that implies an inflation rate of around 1.5%-2.0%, if prices in the long run grow in line with labor costs.

Hence, the labor market is not contributing to inflationary pressures at all at present. Subdued wage growth should have a particularly potent effect in ensuring that core services ex-housing inflation returns to more normal levels.