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The Soft Inflation Narrative, Bonds, and Dollar
Inflation fell last month for the first time in six years, new data showed Thursday, but the seemingly welcome reading is likely a temporary blip. Meanwhile, bonds are rolling over.
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The Personal Consumption Expenditures (PCE) Price Index—the Federal Reserve's preferred measure of inflation—declined 0.1% from May, lowering the annual inflation rate to 3.7% from 4.1%. Markets initially interpreted the report as dovish, sending the U.S. dollar down roughly 1% as investors increased expectations for easier monetary policy.
Our inflation LTCO, a real-time measure of future inflation, tells a different story. Rather than relying on backward-looking inflation data, it rose to 43%, its highest reading in months (see Chart 1). While still below the 50% threshold that signals exceptionally strong inflationary pressure, the increase points to a reacceleration in future inflation. In other words, while headline PCE data suggests inflation is easing, our forward-looking model indicates underlying inflationary pressures are beginning to build again.
Chart 1: Inflation LTCO
This is all taking place after the Federal Reserve left its benchmark interest rate unchanged at 3.50%–3.75% for a fifth consecutive meeting, but the 9–3 vote revealed growing divisions within the central bank. Three policymakers favored a quarter-point rate increase, signaling that the internal debate has shifted from whether inflation is under control to when additional tightening may become necessary. Chairman Kevin Warsh reaffirmed the Fed's commitment to its 2% inflation target, emphasizing that restoring lower inflation does not reverse the higher prices consumers have already absorbed over the past several years. This was discussed in detail in the latest Economy & Stock Report update, 07/30/26 Report - Welcome To The Party, Pal.
Many of today's inflationary pressures stem from supply-side factors, including higher energy costs, geopolitical conflicts, infrastructure constraints, and rising demand driven by AI investment—that cannot be resolved through higher interest rates alone (see Chart 2). While the Fed can influence borrowing costs and demand, it cannot increase energy production, repair disrupted supply chains, or reduce government deficits. As a result, the author contends that relying primarily on interest rate policy overestimates the Federal Reserve's ability to control inflation.
Chart 2: Inflation Drivers
Although the Fed described the economy as continuing to expand at a solid pace, inflation remains above target, and financial markets increasingly expect another rate hike if price pressures persist. The Fed's $6.7 trillion balance sheet, continued Treasury purchases, and the difficult position policymakers face between containing inflation and limiting the government's growing debt-servicing costs remains a persistent concern (see Chart 3). President Trump's calls for lower interest rates are presented as conflicting with broader market realities, as long-term interest rates ultimately depend on investor confidence, inflation expectations, and the supply of government debt.
Chart 3: Money & Credit, Fed Balance Sheet
The Federal Reserve remains trapped between persistent inflation and mounting fiscal pressures. While preserving its credibility requires maintaining its commitment to the inflation target, monetary policy alone cannot resolve problems rooted in excessive government spending, geopolitical instability, and ongoing supply constraints. If inflation remains elevated while economic growth continues to weaken, the Fed risks confronting a period of stagflation—a combination of slowing economic activity and stubborn inflation that leaves policymakers with few effective options (see Chart 4).
Our proprietary indicators reinforce that concern. The EAC's ITCO, our short-term measure of economic activity, is hovering near zero and deteriorating rapidly, while the LTCO, the longer-term trend, has begun to roll over. Together, these signals point to a slowing economy even as inflationary pressures remain firm. The result is a sharp increase in stagflationary risks. By leaving interest rates unchanged, the Federal Reserve has postponed rather than resolved the underlying economic imbalances.
Chart 4: Economic Backdrop
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