A ‘Middle of the Road’ July CPI Likely Gives Fed Breathing Room on Rate Hikes

The July Consumer Price Index report showed inflation edging down, as expected, making it more likely that the Federal Reserve will hold off on raising interest rates in September, economists say.

The Fed has been seen as on the brink of raising rates, with inflation remaining well above its 2% target, upward pressure on energy prices due to the Iran war, and a healthy economy. But with the CPI showing a softening of inflation and the latest jobs report painting a muddy picture of hiring, economists say the Fed has room to pause, even if rate hikes remain possible in 2026.

“There’s nothing in today’s CPI report that demands a September rate hike,” Baird Strategas chief economist Donald Rissmiller wrote in a note to clients on Wednesday.

The Bureau of Labor Statistics reported that the Consumer Price Index increased 3.4% in July from year-ago levels after increasing 3.5% in June. Year-over-year core CPI (which excludes volatile food and energy costs) rose 2.5%, lagging the June rate of 2.6%.

Overall inflation rose 0.1% month over month after falling 0.4% in June. Core inflation rose 0.2%, matching the June decrease.

Economists had expected CPI to rise 0.1% month over month and 3.4% year over year in July, according to the consensus estimates from FactSet. Core CPI was expected to come in up 0.2% month over month and up 2.5% year over year.

July CPI Inflation Report Highlights

• CPI rose 0.1% for the month after falling 0.4% in June.
• Core CPI rose 0.2% after staying steady in June.
• CPI increased 3.4% year over year after increasing 3.5% the prior month.
• Core CPI rose 2.5% from year-ago levels after rising 2.6% in June.

Under the Hood, ‘Typical Month’ for CPI

Going into the July CPI report, economists expected data to reflect recent price pressure trends without much change. For the most part, they said, the July CPI delivered.

“Most major categories behaved as you’d expect in a typical month,” says Morningstar senior US economist Preston Caldwell, who calls the overall report “middle of the road.” He notes that core goods prices rose 0.2% in July, “just a hair higher than normal, perhaps owing to some lingering tariff effects.”

Within the components of the report, gas prices fell 2.9%, in line with economists’ forecasts and subtracting 0.1 percentage points from the overall increase. However, that relief at the pump will likely not carry over into August, thanks to the resumption of fighting in the Iran war. Caldwell says gas prices are on track to add 0.1 or 0.2 percentage points to the monthly change in the August CPI.

“Indexes that increased over the month include medical care, airline fares, communication, education, and recreation,” the BLS report said.

The index for shelter costs rose 0.1 percent in July. “The CPI shelter component is still in a slowing trend (that’s a key anchor),” writes Strategas’ Rissmiller. “Airfare prices popped, possibly reflecting some of the recent fuel price pressures.”

At Bank of America, economists noted the decline in shelter costs but argued that the decline in housing costs is likely to start leveling off: “Housing inflation, rent and owners’ equivalent rent continue to support our view that there’s not much scope for prices to fall further. The [year-over-year] rates have leveled off at 3.2% for OER and 2.9% for rent. The category is highly cyclical and driven mostly by rent renewals. So despite the ongoing weakness in asking rent inflation, rent renewals should remain relatively higher if the economy holds up as we expect.”

CPI Lifts Pressure on Fed to Raise Rates

The as-expected CPI data likely gives the Fed breathing room around interest rates. Ahead of the report, bond futures traders had given a September rate hike a roughly 50-50 chance, according to the CME FedWatch Tool. After the report, the likelihood of a hike is now seen as less than 40%.

“To be fair, there is more data to come before that meeting, in addition to the Fed’s Jackson Hole discussions at the end of the month,” Strategas’ Rissmiller wrote. “So, while the September [Fed] decision is likely another hold, in our opinion, there should continue to be serious discussions about raising the fed funds rate (eventually)—and the hawks could continue to advocate multiple tightening moves depending on their forward-looking expectations.”

Bank of America analysts had been calling for three rate hikes by year-end, but they pared back that forecast after the report’s release. “The somewhat benign inflation data over the last two months have increased the risks that hikes will either be delayed (e.g., they might start in December) or won’t materialize,” they wrote.

Still, the bond futures market shows traders still think the Fed will raise rates before the end of 2026. The chance of a quarter-point hike stood at 45% and two rate hikes at roughly 24%. Chances of the Fed staying pat through year-end were roughly 28%.

Economists note that while inflation is showing signs of softening, it remains above the Fed’s target. “As of July, Core PCE inflation will show something like a 2.6% annualized three-month growth rate and a 3.2% six-month growth rate. Inflation is still uncomfortably above the Fed’s 2% target,” Caldwell says. As a result, “there’s still a very strong likelihood the Fed will hike before the end of 2026. But much will depend on developments surrounding Iran and Hormuz, where the range of outcomes for oil prices (and hence headline inflation).”