The Federal Reserve's Initial August Inflation Forecast Has Arrived, and It Contains a Glaring Red Flag That Can Come Back to Bite Wall Street
Despite a turbulent March, it’s turned into another banner year for Wall Street. The Dow Jones Industrial Average (DJINDICES: ^DJI) and S&P 500 (SNPINDEX: ^GSPC) both climbed to record highs this week, while the technology-driven Nasdaq Composite (NASDAQINDEX: ^IXIC) blasted to an all-time high in early June.
But if there’s one headwind that’s fully capable of knocking this bull market off its pedestal, it’s inflation. Trailing 12-month (TTM) inflation hit a three-year high of 4.2% in May before easing to 3.5% in June, and three of the 12 voting members of the Federal Open Market Committee (FOMC) dissented in favor of a quarter-point rate hike at the July 28-29 meeting. The FOMC is the body, including Fed Chair Kevin Warsh, responsible for setting the nation’s monetary policy.
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While the initial look at the Federal Reserve’s August inflation forecast offers a bit of promise, there’s a glaring red flag that Wall Street has, thus far, ignored.
The silver lining: Headline inflation is expected to modestly taper
The U.S. has dealt with something of an inflation double whammy, courtesy of President Donald Trump’s policies. The president’s tariffs have modestly boosted prices in the goods sector, while the Iran war has done most of the heavy lifting on the inflation front.
For five months (and counting), Iran has closed the Strait of Hormuz to most maritime traffic. This has halted the daily flow of approximately one-fifth of the world’s liquid petroleum and sent fuel prices soaring. A rapid surge in crude oil prices was the spark that sent TTM inflation to 4.2% in May.
The partial silver lining for consumers is that crude oil prices, and thus fuel prices, have eased amid peace talks between the U.S. and Iran. After headline inflation dipped to 3.5% in June, the Federal Reserve Bank of Cleveland’s Inflation Nowcasting tool forecasts a further decline to 3.42% in July and 3.22% in August.
In theory, this steady projected decline in headline inflation may prompt the FOMC to think twice about hiking interest rates.
Ignore this red flag at your own risk
But a forecast drop in headline inflation is only part of the story. The Cleveland Fed’s August inflation forecast also highlights something disturbing.
In May, Core Personal Consumption Expenditures (PCE), which excludes volatile food and energy costs, jumped to 3.4%, its highest level since October 2023. Whereas headline inflation could fall a full percentage point between May and August, based on the latest Cleveland Fed forecast, Core PCE is expected to hold steady at 3.31% in July before reaccelerating to 3.36% in August.
What the Fed’s Core PCE projections show is that Iran-war-driven inflation is no longer just an energy-supply disruption issue. The impacts of this conflict are reaching the broader economy, with altered shipping routes, new suppliers, and higher costs for select goods hitting consumers in their pocketbooks.
Core PCE has historically been one of the FOMC’s favorite inflationary measures. The price stickiness of Core PCE, even in light of a forecast decline in headline inflation, firmly leaves rate hikes on the table. If the Federal Reserve does raise interest rates, it could slow or stall the partially debt-financed artificial intelligence data center build-out that’s propelled the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite to fresh highs.
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The Federal Reserve’s Initial August Inflation Forecast Has Arrived, and It Contains a Glaring Red Flag That Can Come Back to Bite Wall Street was originally published by The Motley Fool