The Inflation Outlook and Fed Policy under New Leadership

[Music] Hello and welcome to Notes on the Week ahead, a JP Morgan Asset Management podcast that provides insights on the markets and the economy to help you stay informed in the week ahead. [Music] Hello, this is David Kelly. I'm Chief Strategist here at JP Morgan Asset Management. Today is June 15, 2026. Last Wednesday's CPI report, while not a surprise, still showed a year-over-year inflation rate of 4.2 percent, higher than in any month since April 23. For investors, this raises a number of questions. First, is this the peak for US inflation and, if it is, how fast will inflation fall from here? Second, are we looking at the right inflation rate anyway, given differences between CPI and PC deflators, headline and core measures, and the new Fed chairman's preference for trim to mean and median readings? Finally, what does the inflation outlook imply for this week's Fed decision and the direction of monetary policy and interest rates? Consumer prices rose by 0.47 percent in May, resulting in a year-over-year increase of 4.17 percent. Most this gain, 0.28 percent to be exact, was due to a 7 percent jump in gasoline prices. However, the inflation story was more mixed elsewhere, boosted by gains in electricity prices to back-up prices in airline fares, but restrained by reported declines in the prices of new vehicles, medical commodities and auto and health insurance. All that being said, it's possible that May was the high watermark for the current inflation surge. First, taking a look at June, the average price of a gallon of regular gasoline peaked at $4.56 on May 21, and has fallen back to $4.07 since. Even if it rose a penny a day for the rest of the month, the June average would be 4.17 percent down 7.2 percent from May and taking 0.26 percent out of a month to month CPI inflation. Now since the monthly inflation rate in June 2025, it was 0.25 percent, a year-over-year CPI inflation will fall between May and June, unless all other prices rise by more than 0.52 percent for the month, which is well above the current inflation trend. Thereafter inflation could drift down further, under some key assumptions. The most important of these is that the interim peace deal announced by the United States in Iran on Sunday results in a resumption of a free flow of traffic through the state of Hormuz. Difficulties remain, including still-to-be-conducted negotiations on Iran's nuclear capabilities and the willingness of the Israel and Hezbollah to refrain from hostilities in Lebanon. However, both the United States and Iran have a strong reason to try to reopen the strait and keep it open. On the U.S. side, the free flow of oil and other key exports in the region should reduce inflation ahead of the midterm elections. The Iranian regime also clearly has an incentive to sustain a solution that allows it to export oil more freely and eliminates the risk of U.S. attacks. Of course, even when the strait is reopened, it will take some time to restore normality to global energy supplies. However, a continued rapid release of oil from the U.S. Strategic Petroleum Reserve, combined with similar actions overseas, could result in the normalization of gasoline prices that precedes more quickly than any normalization energy supply chains. A second assumption is a continued gradual decline in tariffs. Average gross tariff revenue in the fourth quarter 2025 equals 11.5% of goods imports. However, in the aftermath of the February Supreme Court ruling against the IEPA tariffs, we estimate that this average tariff rate has fallen to just 7.8% over the past three months. The administration initially tried to replace some of the IEPA tariff revenue with 10% tariffs under Section 122 of the Trade Act of 1974. This was also ruled to be illegal in May 7th ruling by the Court of International Trade, although the government is still collecting revenue from these tariffs pending appeal. As a more permanent solution, the administration has now invoked Section 301 of the Trade Act of 1974 to propose tariffs of 10% of six countries and 12.5% of 54 more, based on their alleged unfair trade practices due to forced labor. These new tariffs, which exclude goods covered by the U.S. MCI, the U.S. MCA, will also likely be challenging. It may be that the administration finally finds some tariffs of the president can impose unilaterally or that Congress actually approves. However, given both legal challenges in the general unpopularity of tariffs, we assume that the average tariff rate in the fourth quarter this year and going into next year will be 7.5% of imports. Far below the 11.5% of imports seen in the fourth quarter last year, reducing pressure on consumer inflation. The eagerness of imports is to pass these tariffs onto consumers may also be somewhat mitigated by now substantial refunds of previous IEPA tariff revenue. A third assumption is that shelter costs continue to back off. The CPI measures were rent and owners of equivalent rent, which together comprised 33.5% of the index, were distorted by the government shutdown last October. However, by May these distortions that worked their way through the system, giving a clean reading to these measures and showing 2.9% and 3.3% year of year growth and rent and owners equivalent rent respectively. These readings were down from 3.8% and 4.2% respectively a year earlier. However, they both still overstated current reality in the housing market. The latest available data from Zillow, Co-star, ApartmentList and Realtor.com show year-of-year rent changes and new leases ranging between -1.7% and +1.8%. According to the Census Bureau, the rental vacancy rate in the first quarter was 7.3%, its highest level since 2017, as a falling working age population, damage demand by more than a pullback in multi-family unit construction over the past 2 years has limited supply. This should result in a slow and steady decline in shelter inflation into 2027. Finally, there's just no evidence that higher inflation is feeding through to higher wages. Despite a relatively tight labor market in the surge in inflation, average hourly earnings for all workers was just 3.45% in May. The second smallest gain in 5 years, resulting in a year-of-a-year decline in real wage rates for a second consecutive month. Fewer than 6% of US private sector workers are members of a union. There are very few strikes demanding higher pay, and workers appear either to be unwilling to demand or unable to achieve significant real wage gains, even in the face of rising property. This last factor is really key to a lack of stickiness in US inflation, and our baseline forecast is that CPI inflation drift down to 3.3% year-of-year by December and then tumbles to 1.8% year-of-year by next May, reflecting last month's very high reading. Thereafter, for the rest of 2021, it stabilizes at roughly 2% year-of-a-year. With CPI inflation running at 4.2% and projections remain above 3% through the end of the year, it's hard to argue that inflation is even close to the Fed's target. However, there is some question about which inflation measure to focus on, particularly given Kevin Moore's preference for trimmed averages which he alluded to at his April 21st confirmation hearing. So, at the risk of being a bit pedantic, here's a situation. The best known inflation measure is consumer price index. However, the Federal Reserve and its annual statement on long-long run goals and monetary policy strategy explicitly sets a target of 2% for the personal consumption defasure. The consumption defasure, unlike the consumer price index, is a chain-weighted index that takes into account quantity changes over time in consumers consumption of goods and services, and as such, it is at least theoretically a better measure of inflation from the perspective of consumer welfare. While the Fed's official target is a headline consumption defasure, many economists both inside and outside the Fed prefer to focus on the core consumption defasure, which excludes price changes in the volatile food and energy categories. The argument is that food and energy prices are volatile, and therefore if you want to get a sense of where inflation is headed, you're better off looking at the core consumption defasure. In his April 21st testimony, Chairman Worsh took this a step further, arguing that trimmed to mean measures can do a better job at deducing the underlying inflation trend by ignoring the biggest price changes either way, regardless of whether they are part of food and energy in categories. He also asserted that looking at these measures, inflation has improved somewhat over the past year. He has a point, but not one that justifies a cut and interest rate anytime soon. A first May year of year inflation, including our forecast for yet to be released numbers, was 4.2% is measured by headline CPI, 4.0% is measured by the headline consumption defasure, 3.3% is measured by the core consumption defasure, and 2.4% is measured by the Dallas Fed trimmed mean consumption defasure. All of these numbers are above the Fed's 2% target, whereover the Dallas Fed measure is likely the lowest stable of the four and may not fall below 2% even in 2027. Second, if an inflation index is being used to assess the impact of increases in the cost of living on ordinary households, and then the Fed should focus on headline rather than core inflation. The average family cannot exclude food and energy from their budget. Conversy of the reason for looking at core measures or trim measures is to forecast future inflation, it makes more sense to apply deeper analysis looking at current inflation trends, but also considering the impact of policies elsewhere in Washington, including tariffs, global supply chains, and any potential future fiscal stimulus. Finally, even if inflation was headed quickly below 2%, the Fed should not ignore broader economic or financial conditions. There is no evidence that the economy is on the brink of recession. Consumer spending growth appears steady, AI-related capital spending is booming at labor market indicators, such as job openings and unemployment claims, which are relatively strong. However, turning to financial conditions, the US equity. marketing market is currently on track to achieve strong gains for a fourth consecutive year, fuel and consumer investments spending, but also increasing the risk of financial bubbles. It's not at all clear that a cup of interest rates at this time would boost your economic growth. It would, however, provide further cheap funding for speculation across financial markets, which would increase the danger of a bubble bursting in the next few years, potentially doing considerable damage to both the economy and financial markets. This Wednesday, Chairman Worshnaz Colleagues' Federal Reserve will publish new economic projections as part of their post-FOMC communications. We expect them to modestly increase their estimates of economic growth in inflation for both this year and next, and to project a slightly lower unemployment rate. This being the case, we also believe that they will remove their expectation of any rate cut for 2022. The new Fed Chair, despite relatively dovish comments and his confirmation hearings, will be very likely to go along with the majority in this decision. No Fed Chair has ever publicly voted against the majority of the FOMC. And since a crucial part of Chairman Worsh's job will be to form a consensus in the committee, it will be very odd if he starts his tenure by voting against the majority of you. He will, however, likely argue strongly against the rate hike the futures markets have priced in for later this year, and in this debate he's likely to prevail. While the economy and financial markets need a rate cut at this time, we expect both growth in inflation to slow entry in 2027. And so long as they are trending down, there will be little reason for the Fed to try to micro-marrage the pace of their decline. While the Fed Chair may have to abandon his short-term aspirations for easier monetary policy, he may well have more success in convincing his colleagues to be less active in general, in an environment where it's not clear that Fed activism will do any good. For investors, this life he means that the direction of long-term interest rates will be dictated by fiscal policy more than monetary policy in a year's head. This should imply a slow drift up in long rates, due to accumulating government debt. Not giving investors a reason to abandon bonds, or rather to recognize that, over the next few years, high quality fixed income should be owned for income and diversification, rather than for capital gains. Well, that's it for this week. Please tune in again next week, and if you have any questions in the meantime, please reach out to JP Morgan Rep. This content is intended for information only based on assumptions in current market conditions and are subject to change. 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