About the only good thing that can be said about the incoming PCE inflation data: It could have been worse. At an annual rate, the month-over-month overall PCE inflation rate popped up to 3.22% in August from 1.97% in July; the corresponding core PCE inflation rate slipped from 2.86% to 2.76%. The annual (year-over-year) PCE inflation rate rose from 2.60% to 2.74%; core, from 2.85% to 2.91%. Finally, our measure of trend PCE inflation rose to 2.72% from 2.46%; trend core PCE inflation fell slightly to 2.84% from 2.88%.
And exactly what is so troubling in terms of the real side of the economy? Granted, there have recently been some very low employment numbers. Yet, a broader look at the labor market doesn’t add up to ringing the alarm bell and lower rates. In terms of job openings, outside of the pandemic, the rate of job openings is pretty much the highest it has ever been. There has been no obvious change in the rate of layoffs. The unemployment rate remains quite low by historical standards. Real gross domestic product was recently revised up, from 3.3% to 3.8%. Using monthly data on non-farm payroll employment, industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales, the probability of being in a recession (here is the Piger website) is 1.0%.
Policy Outlook
In the FOMC’s recent announcement reducing its policy rate by 25 basis points, the committee expressed its opinion that the balance of risks has shifted towards unemployment…and away from inflation. We stand by our earlier opinion that job number 1 for the Fed is low and stable inflation; good real-side outcomes will ultimately result from executing on the inflation front. The risk to the policy outlook is that 3% inflation is the new de facto target, up from the stated 2% target. Already, short-term inflation expectations have risen. Experience from the 1970s and 1980s tells us that it is economically painful to reduce expected inflation. Responsible policy would see the Fed bringing inflation back down to its 2% target, with fiscal policy addressing the jobs situation.
The BLS announced that the Consumer Price Index (CPI) increased 4.69% on an annualized basis. There is little doubt that inflation is moving in the wrong direction from the Fed’s 2% target. The year-over-year measure grew 2.94%. Our preferred trend measure jumped more than a half percentage point, from 2.42% in July to 3.18% in August. All measures have shown a distinct upward trend since April.
The core measure (excluding food and energy) shows a similar pattern. The annualized increase for August jumped to 4.23%, the year-over-year measure grew 3.11% and the trend measure popped to 3.38%.
While there is, and will be, considerable chatter over the effects of tariffs on goods prices, one would imagine that service sector prices may be more immune to the tariffs compared to goods prices. Unfortunately, the news is not good for service sector prices either. All of the measures are well above the 3% mark: 3.69% for trend, 3.90% annualized and 3.81% year-over-year.
what does this mean for policy?
Obviously, the inflation numbers have put the Fed in even more of a quandary. If it were not for the increase in the service sector prices some people could claim that the tariffs have increased the price level but may not have future inflation effects. While the Fed’s preferred measure of inflation comes from the Personal Consumption Expenditures (PCE) price index (to be released on September 26, after the upcoming FOMC meeting next week), the two price indices tend to move together.
Although there has been some weakness in the real side of the economy, the labor market more than GDP, the FOMC certainly does not want to see an inflationary episode similar to what happened a few years ago. Here is a longer time series of the core CPI:
The high CPI inflation during 2022 meant that real purchasing power was eroding because prices were outpacing hourly earnings growth.
However, initial claims for unemployment insurance, released today, showed a decidedly upward tick, providing some more evidence of a weakening labor market.
Overall, it is our view that the inflation risks outweigh the real-side risk. There’s already chatter that maybe 3% is the new 2%.
The Bureau of Labor Statistics (BLS) announced that the establishment survey showed that payroll employment was little changed, rising 22,000. In addition, June was revised down 27,000 and July up slightly, 6,000, for a net decline over the previous two months of 21,000. The government sector declined by 16,000.
The goods producing sector shed 25,000 and has declined in each of the last four months. Since July of 2000 employment in that sector has declined by about 3 million jobs. There has been a lot of research on what is known as the “China shock” that occurred when China entered the World Trade Organization (WTO) in 2001. Here is an article discussing some of the findings of the research.
Policy Outlook
At this stage, there is little doubt that the FOMC will cut the Fed funds rate at its upcoming September meeting. The big question is: How will markets respond? If the Fed is seen as capitulating to the White House, inflation expectations will rise, and so will market interest rates. However, those on the FOMC who are calling for a rate cut can make plausible arguments unrelated to any pressure from the White House. Our view is that inflation is still not under control and has been increasing of late and so cuts to the fed funds rate is premature.
The BEA announced that inflation as measured by the annualized month-over-month change in the Personal Consumption Expenditure (PCE) price index fell from 3.49% (June) to 2.40% (July) on an annualized basis. Our corresponding measure of trend inflation also fell, from 2.63% to 2.55%. However, the annual (year-over-year) measure rose slightly, from 2.56% to 2.60%.
As is well known, the FOMC concentrates more on core PCE inflation (that is, excluding the “volatile” food and energy components). Core inflation rose across the three measures we regularly report. The annualized month-over-month rate rose from 3.20% to 3.33%; the year-over-year from 2.77% to 2.88%; and our measure of trend from 2.80% to 2.98%.
The PCE inflation results were foreshadowed by the earlier CPI release.
Earlier this week, the BEA also released its second estimate for quarter 2 Gross Domestic Product. In brief, output growth was revised up from 3% to 3.3%.
Policy Outlook
We’ll organize our discussion of the policy outlook around the Taylor rule which prescribes setting the FOMC’s policy rate, the Federal funds rate, based on: (1) the “neutral” Fed funds rate, given by the sum of the real interest rate and the inflation rate; (2) how much the inflation rate exceeds target; and (3) some measure of real activity like the output gap (potential output less actual) or the unemployment rate gap (the actual unemployment rate less its natural rate). (For those wishing to play around with different scenarios, the Atlanta Fed has a web page for that.)
While in theory each of these components is well defined, in practice they are not. Start with inflation. Measuring inflation seems pretty straightforward, particularly since the FOMC has stated its preference for core PCE inflation. At what horizon should inflation be measured? As we’ve harped on in the past, the month-over-month rate is too volatile while the year-over-year rate takes a long time to capture changes in trend. Suppose that the FOMC uses something conceptually similar to our measure of trend inflation. We still face the problem of accounting for transitory phenomena like Trump’s tariffs. Some folks (including some members of the FOMC) argue that these tariffs have pushed up the price level without changing the underlying trend. As a result, measured inflation will be higher, but this does not reflect a change in trend. As always, the devil is in the details: How much of current inflation is due to these transitory factors?
Next, measuring gaps is hard and subject to measurement error. The output gap requires knowing potential output which is the level of aggregate output that the economy could produce with current resources (labor force, capital, etc.) used at typical intensities. Similarly, the unemployment rate gap depends on the natural rate of unemployment: the rate that would prevail in the long run absent shocks. Both potential output and the natural rate of unemployment need to be estimated and so are subject to uncertainty. Further, the current environment is sending mixed signals regarding the real side of the economy. Output growth for the second quarter is humming along quite nicely, but this growth comes on the heels of a disappointing first quarter. The revised job creation data suggest an anemic labor market, but the unemployment rate is still low.
Finally, the neutral Fed funds rate suffers not only from the inflation issues discussed above, but also problems in measuring the real interest rate. The problem for those arguing that the current Fed funds rate is too restrictive — meaning that it’s above its neutral rate — is that we don’t really know that neutral rate.
Those advocating cuts to the Fed funds rate argue some combination of: (1) monetary policy is too tight: the Fed funds rate is well above its neutral level; (2) while inflation is above target, this is due to transitory factors like Trump’s tariffs; and (3) the real side of the economy is weak as evidenced by the job creation numbers.
The case for no change is built on: inflation is too high (and increasing of late) and therefore a restrictive monetary policy is appropriate, and there are mixed signals from the real side of the economy.
The political pressure being applied to the FOMC adds yet another complication. To grasp the nature of this problem, keep in mind that the Fed controls one interest rate: the Federal funds rate which is an overnight rate relevant to banks. The following discussion also makes use of the Fisher equation which states that the nominal interest rate is the sum of the real interest rate and expected inflation. Given that inflation is above target, the risk of cutting the Fed funds rate is that market participants may view the Fed as caving to political pressures to lower interest rates. In turn, market participants may well question the Fed’s credibility and its commitment to low, stable inflation. As a result we would expect a rise in inflation expectations. Then, via the Fisher equation, such an increase in expected inflation will lead to a rise in market interest rates in order to compensate investors for the higher inflation they anticipate. Paradoxically, the political pressures on the Fed make it important for the Fed to keep the current level of the Fed funds rate in order to maintain the Fed’s political independence and credibility. No one wants to be painted as the second coming of Arthur Burns. Here is a fascinating podcast describing how Arthur Burns capitulated to Richard Nixon, bringing about the worst inflationary episodes in recent U.S. history.
The BLS announced that inflation as measured by the consumer price index fell to 2.38% on an annualized basis, down from 3.5% in June. The year-over-year number climbed to 2.73%, the highest reading since February, and an increase from June’s 2.67%. The annualized core CPI jumped from 2.77% to 3.74%. Our preferred trend measure for the CPI fell slightly from the previous month, from 2.44% to 2.42%. And our core trend measure rose to 2.95% from 2.45%.
The Fed’s preferred measure is the Personal Consumption Expenditure price level and will be released on August 29, providing more information on the direction of prices in the economy. While the two measures, CPI and PCE, do not move in lock-step over longer periods of time they tend to move in the same direction. If PCE inflation for July is similarly higher than in June (as seems likely given CPI inflation), it will be difficult for those FOMC members advocating for a rate cut to make a compelling case.
There were several data releases as well as a Fed meeting this week. The Jobs Openings and Labor Turnover Survey (JOLTS) was released on Tuesday. The release reported that there was little change in job openings, hires and total separations. The graph below shows that there are still slightly more jobs available, 7,437,000 than unemployed persons, 7,015,000.
Another useful statistic is the rate of job openings, determined by the number of openings divided by the number employed plus openings, that is, filled and unfilled jobs. This number has been steady over the past year once the outsized rates in the post-pandemic period eased. The other rates in the graph are found by dividing the level by total employment. The quit and layoff rates have been flat in 2025.
On Wednesday the BEA announced that real GDP increased 3.0% on an annulaized basis in the second quarter. Consumption increased 1.4%, investment fell 15.6% and government consumption and investment increased 0.4%. Exports and imports declined, 1.8% and 30.3%, respectively.
A different way of thinking through the above National Income and Product Accounts (NIPA) data is in terms of contributions to output growth. The 3% growth in output can, then, be decomposed as: 1 percentage point due to consumption, 0.1 percentage points due to government spending and 5.1 points due to imports. Investment exerted a 3 percentage point drag on output growth while exports contributed -0.2 percentage points. Of particular importance is the 30.3% decline in imports following a 37.9% increase in Q1. A reasonable interpretation of this data is that Trump’s promised tariffs boosted imports in the first quarter (as businesses imported goods ahead of the tariffs). The large negative growth of imports in the second quarter then reflects an “unwinding” of the first quarter hike in imports.
On Thursday of this week the BEA announced the PCE price index from the Personal Income and Outlays release. The release showed an increase in the PCE price index of 3.42% on annualized basis after rising 2.03% in May. Our preferred trend measure increased to 2.66% from 2.28%. The PCE core measure cruised past the 3% mark to 3.12%, about half a percentage point higher than the previous month. Our trend measure of PCE core inflation rose from 2.69% to 2.83%. These PCE inflation numbers were largely foreshadowed by the CPI data released over 2 weeks ago.
Finally, at the end of the week, the BLS announced that payroll employment increased 73,000. Even worse, there were also downward revisions totaling 258,000; 125,000 in May and 133,000 in June. There was one small positive bit in the report, average hours of work increased to 34.3 from 34.2.
The goods producing sector shed 13,000 jobs for the third consecutive month. The service sector, however, saw continued growth, increasing 96,000. Interestingly, the diffusion index (indicating the fraction of firms increasing increasing or not changing employment) rose to 51.2, meaning that more firms increased employment than decreased it.
The household survey also showed considerable weakness, employment fell 260,000 and the labor force participation rate declined to 62.2 from 62.3. The unemployment rate inched up slightly from 4.12% to 4.25%.
Policy Outlook
The FOMC now finds itself in an unenviable position of seeing inflation well above target and a weakening real side of the economy. It may seem strange to describe the real side as “weak” when output recorded a 3.0% increase. The problem is the effect of tariffs on imports. We don’t want to make too much of the decline in exports, but will be watching to see if U.S. trade partners respond to U.S. tariffs by pulling back on their imports of U.S. goods and services – which will be reflected in lower U.S. exports. The -15.6% growth in investment similarly looks bad except that it comes on the heels of a very robust 23.8% growth rate in the first quarter.
On the real side, labor market developments are starting to turn down. We were comforted by the solid job gains in April and May, but the revised data suggests a more anemic job market. While the 73,000 jobs added in June look better than the revised numbers for April and May, that’s not saying much. The weak labor market would seem the best case for those pushing for a Fed funds rate cut.
On the other hand, inflation continues to run higher than the FOMC’s 2% target and is now moving in the wrong direction (that is, away from 2%). Some policymakers are arguing that the effect of tariffs will be a level shift in prices that will have no lasting effects on inflation. While this is plausible, this case would be stronger if there were evidence in its favor. We’ve yet to see such evidence. Remember that policymakers also argued that the effect of the pandemic would similarly be a left shift in prices with no lasting effects on inflation. As Montgomery Scott famously said, “Fool me once, shame on you; fool me twice, shame on me.”
Over the past few years, the FOMC has tried to engineer a so-called soft landing in which inflation is brought under control without causing a recession. The Committee now faces rising inflation and a potential recession. Since the Fed only has one instrument (the Fed funds rate), it cannot address the two targets, inflation and unemployment. Job one for monetary policymakers is to keep inflation in check. Let fiscal policymakers handle the real side.
Late this month, we’ll get data on core PCE (personal consumption expenditure) inflation — the measure favored by the Fed. In the meantime, we have CPI inflation which is a noisy signal of what to expect of PCE inflation. The signal points to higher inflation. On a year-over-year basis, core CPI inflation rose from 2.77% to 2.91%. However, this measure of inflation responds slugglishly to changes in trend. The annualized month-over-month rate popped up from 1.57% to 2.77%, or 1.2 percentage points. Meanwhile, our trend measure increased by 0.15 percentage points, from 2.30% to 2.46%.
Overall CPI inflation paints a similar picture: the month-over-month rate rose from 0.97% (annualized) to 3.50; the year-over-year from 2.38% to 2.67%; and our trend measure from 1.91% to 2.43%.
Policy Implications
No doubt, some will attribute at least some of this increase in CPI inflation to the effects of the Trump tariffs. In our opinion, this sort of attribution will require deeper analysis than is afforded by the Bureau of Labor Statistics’ CPI release, and may only be knowable when we have several more months (or years) of data.
If PCE inflation for June (to be released on July 31) similarly increases, FOMC doves and those auditioning to be the next Chair of the FOMC will have a hard time making a convincing economic case for lowering the Fed’s policy interest rate; especially since the real side of the economy has managed to withstand tariff threats and geopolitical intrigue.
According to the BLS Employment Survey, the U.S. economy added another 147 thousand jobs in June — a very respectable number. Although the private sector saw a weak employment increase of 74 thousand.
The BLS noted gains in the government sector (gaining 73 thousand jobs, despite a reduction of 7 thousand at the Federal level) and health care (up 39 thousand jobs).
Average hours of work fell to 34.2 from 34.3 and has been oscillating between the two for several months.
From the Household Survey in the same BLS release, the unemployment rate dipped from 4.24% in May to 4.12% in June.
One dark spot in the employment outlook is that continuing unemployment insurance claims have risen in June. This increase may reflect increased difficulty of the unemployed to find suitable jobs.
JOLTS (Job Openings and Labor Turnover Survey) allows for a deeper dive into the data; this data was released on July 1 and includes data for May but not June. It continues to be the case that there are more available jobs than folks classified as “unemployed” (actively seeking a job). Of course, aggregate measures like these say nothing about the match between skills needed for open jobs, and the skills of the unemployed.
As the job openings rate has fallen since 2022, so has the hiring rate and the quit rate. Since JOLTS is a relatively new survey, it covers a span of time with very few complete business cycles. Consequently, it’s difficult to say what typcally happends to the JOLTS rates at the oneset of a recession. That said, around a recession as the labor market tightens we would expect to see a fall in the quit, openings and hiring rates, and a rise in the layoff rate. Thus far in 2025, it is hard to see any such changes.
While there were some spots of concern, the labor market shows little signs of weakening. Indeed the strength of the June report gives amunition to those on the FOMC advocating for no action at its July meeting.
The BEA’s personal income and outlays release for May provides a mixed message on PCE (personal consumption expenditure) inflation. Core PCE inflation which excludes the more volatile food and energy components rose from 2.58% to 2.68% on a year-over-year basis. This is the measure of inflation favored by the Federal Open Market Committee. The month-over-month rate popped up from 1.64% to 2.17% at an annual rate. And yet, our trend measure of inflation fell from 2.56% to 2.43%. Why the difference in these measures of inflation? Mechanically, the year-over-year rate is the average of the last 12 month-over-month inflation rates. The increase in the year-over-year inflation rate reflects the fact that this 12 month “window” added May 2024 (2.17%) while dropping May 2023 (0.98%). Meanwhile, our trend measure fell because the May 2024 month-over-month inflation rate (2.17%) is less than our trend measure for April (2.56%).
The picture is largely the same when looking at the overall PCE inflation rate: The month-over-month rate rose from 1.42% to 1.64%; the year-over-year rate edged up from 2.20% to 2.34%; and our trend measure eased from 2.25% to 2.04%.
The BEA release also shows a decline on a month-over-month basis in nominal personal consumption expenditures. However, this is a very volatile series. The year-over-year growth rate smooths out these fluctuations. Over the past few years, personal consumption expenditure growth has been falling. We place little importance in the month-over-month decline reported for May.
Real personal disposable income fell in May when computed on a month-over-month basis (its growth rate was negative) while the year-over-year growth rate declined.
Today, the University Of Michigan released its survey-based measure of inflation expectations over the next 12 months. In brief, consumers’ expectations of inflation have risen in 2025 and now sit at nearly 7%. Alternatively, the 5-year Breakeven Inflation Rate measures the average inflation rate over the next 5 years based on 5-Year Treasury Constant Maturity Securities and 5-Year Treasury Inflation-Indexed Constant Maturity Securities. Given that the inflation-indexed security is based on the CPI (consumer price index), and CPI inflation tends to run 0.5 percentage points higher than PCE inflation, it seems that investors expect inflation to average very close to the Fed’s 2% target.
The University of Michigan also released its measure of consumer sentiment (or “confidence”). While this series exhibits considerable volatility, it seems fair to say that consumer sentiment has dropped quite sharply in 2025.
Policy Implications
Is it time for the FOMC to start lowering its policy rate? Jockeying by potential candidates for the Chair of the FOMC suggests it is. Based on the data, it’s hard to make a strong case for lowering the Fed funds rate at this time. The data analyzed above tells us that inflation is still running a bit too hot relative to the Fed’s 2% target for core PCE inflation. The labor market continues to record solid employment gains. In about a month, we will get an initial reading on Gross Domestic Product for the second quarter, but at this juncture, it seems likely to be a solid quarter. One could argue that the FOMC can raise rates again if inflation pops up. But this sort of interest rate volatility is something that the Fed tries to avoid, and it always seems more difficult to raise rates than to lower them. In summary, the economic case points to maintaining the Fed funds rate at its current level.
The FOMC announcements have typically called for no change in policy in order to wait for more conclusive data, given the uncertainty in tariffs as well as geo-political concerns. There does not seem to be much in the way of additional clarification, other than PCE core inflation has been riding steadily above the Fed’s preferred target.
The BLS’s announcement of the May CPI showed little change in the inflation rate. On a year-over-year basis, the CPI inflation rate ticked up from 2.33% in April to 2.38% in May. However, the annualized monthly inflation rate fell from 2.68% to 0.97%. Our measure of trend CPI inflation fell from 2.37% to 1.91%.
The situation was largely similar with regards to core CPI (excluding food and energy) inflation. The year-over-year measure barely changed, from 2.78% to 2.77%; the montly rate fell from 2.88% to 1.57%; and our trend measure dropped from 2.66% to 2.30%.
Fed watchers know that the FOMC focuses on core PCE inflation, not CPI inflation. That said, there’s considerable overlap in these two price level measures, and in general the two measures of inflation move together. Based on the CPI report, it seems unlikely that core PCE inflation will rise markedly. That inflation remains somewhat subdued and the real economy has not shown any real signs of slipping, it appears unlikely that the Fed will make any interest rate movements soon.
