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The Fed's Divide: Will Core PCED Settle The Debate?
The FOMC is divided between a hawkish and an owlish camp. The hawks include Dallas Fed President Lorie Logan, Cleveland Fed President Beth Hammack, and Minneapolis Fed President Neel Kashkari, all of whom dissented at the July FOMC meeting in favor of a rate hike. Logan argues that policy is no longer restraining the economy. Hammack recently said that "now is the time to act" and that the latest inflation data are "not enough to convince me the tide has turned." Kashkari has warned that delaying action could eventually require more aggressive rate hikes. The owlish camp includes the likes of New York Fed President John Williams and Richmond Fed President Tom Barkin. Barkin recently argued that much of today's inflation reflects tariffs, higher oil prices, and AI-related demand shocks. He believes that current interest rates may still be restrictive enough to bring inflation down. Williams's framework contends that core PCED inflation near 0.2% m/m would be consistent with continued disinflation over the rest of the year. Readings closer to 0.3% would suggest more persistent inflation and could warrant a policy response, in his view. Following this week's July CPI and PPI reports, which camp has gained the upper hand? Consider the following: (1) PPI for final demand. Final-demand PPI was unchanged in July as a 3.1% m/m drop in energy and food prices offset inflation elsewhere in the producer pipeline (chart). Lower fuel costs lowered transportation and warehousing services, which fell 1.8%. On the other hand, the PPI excluding food, energy, and trade services rose 0.4% m/m. On a yearly basis, final-demand PPI moderated but remained elevated at 4.7%, with services up 3.9% and goods up 6.5% (chart). (2) PPI for consumption. The PPI for personal consumption, a key input into the Fed’s preferred PCED inflation gauge, rose 0.1% m/m in July (chart). Excluding food and energy, it was up 0.4%. That's a hot number, though the PPI excludes shelter costs, which have been cooling. Core PPI for personal consumption moderated slightly to 4.4% y/y, but remained above both core PCED and core CPI inflation, suggesting that upside risks to consumer inflation remain elevated (chart). (3) Supercore inflation. The PPI supercore inflation rate has moderated recently but remained elevated at 4.2% y/y in July, more than double its pre-pandemic trend (chart). (4) Core PCED. With July CPI and PPI now in hand, most forecasters expect core PCED inflation to rise 0.2%-0.3% m/m in July. The median Wall Street estimate is 0.22%, while the Cleveland Fed’s Inflation Nowcasting model projects 0.25%. The framework recently outlined by New York Fed President John Williams suggests a reading closer to 0.2% would likely reinforce the case for a hold in September, while one closer to 0.3% would strengthen the case for a September hike. Markets leaned toward the former after the PPI was released, as the probability of a September hike declined to 34.8%, down from more than 40% before the release. (5) Jobless claims. Initial jobless claims edged up to 209,000 in the week ended August 7 but remained historically low (chart). The four-week average held at its lowest since October 2022, while continuing claims declined. (6) GDP. Growth also looks solid. The Weekly Economic Index rose 2.7% y/y in the week ended August 7, consistent with roughly 3% real GDP growth (chart). The Atlanta Fed’s GDPNow model currently projects 5.8% real GDP growth in Q3, supported by consumer spending and business fixed investment (chart). (7) Federal budget deficit. The federal budget deficit widened to $432 billion in July, the largest monthly shortfall since March 2021, bringing the 12-month deficit up to $2.0 trillion (chart). Long-term US Treasury yields have been rising partly in response to increased government debt supply (chart). Recent Treasury auctions showed the pressure: The 10-year Treasury yield rose to its highest level since 2007, while the 30-year rose to its highest level since 2001. Of course, higher long-term yields reflect several additional factors besides the federal budget deficit. One is a higher neutral interest rate, driven by strong AI-related demand for capital at a time when structural forces such as population aging and immigration restrictions are weighing on national saving. Long-term yields have also been supported by economic resilience and increased debt issuance by hyperscalers to finance AI-related investments. We view a 10-year Treasury yield between 4.00% and 5.00% as broadly consistent with these fundamentals. The Bond Vigilantes are not revolting yet.
AI, Oil & Military Technology
Demand for AI computing continues to exceed supply. That was the reassuring takeaway from three companies’ June-quarter earnings reports that breathed new life into worry-prone AI stocks. Jackie summarizes how the CEO of CoreWeave characterized the strong and rising demand for his company’s cloud computing services. … Also: Oil prices haven’t surged catastrophically as the Iran/US war has dragged on—yet. The measures tethering prices have time limits, though. The longer the war lasts, the higher oil prices could go. … And in our Disruptive Technologies segment, a look at the military uses of drones.
July CPI: The Fed Is Still In The Woods
The July CPI report was good news for Fed officials and the rest of us. Inflation is moving closer to the Fed's 2.0% target. However, the inflation picture may not be as bright as the CPI report suggests. New York Fed President John Williams recently said that if core PCED inflation readings remain above 0.2% m/m during the second half of this year, then the Fed should tighten monetary policy. The Cleveland Fed's Inflation Nowcasting model continues to estimate a 0.25% m/m increase in core PCED inflation for July and 0.27% for August. The Fed gives more weight to the core PCED than the core CPI in setting monetary policy. That helps explain why the 2-year US Treasury yield remains roughly 75 basis points above the federal funds rate, suggesting that fixed-income markets continue to expect a Fed rate hike in the coming months (chart). The 10-year Treasury yield also remained elevated, at 4.68%, after the CPI report. Nevertheless, the July CPI report was broadly a good one. So the odds of a Fed rate hike at the September meeting declined on the news. Consider the following: (1) CPI inflation (m/m). July's headline CPI rose by just 0.1% m/m, as declines in energy-related categories weighed on the index (chart). Core CPI rose at a subdued pace of 0.2% in July, indicating that underlying inflation pressures did not intensify materially during the month. Core goods and core services prices increased by just 0.2%. The durable goods CPI rose 0.3% m/m in July (chart). Prices for computers, peripherals, and accessories surged 3.2%, which suggests that rising memory-chip costs tied to the AI buildout are feeding through to consumer electronics prices. The nondurable goods CPI fell 0.3% m/m, as declines in energy-related categories more than offset price increases elsewhere (chart). Notably, prices for computer software and accessories rose another 0.5% after jumping 2.3% in June, reflecting pricing power from strong demand for AI-enabled software. The CPI for services rose 0.2% m/m (chart). Weak shelter inflation, partly reflecting a 1.1% decline in lodging away from home, and a 2.1% drop in car and truck rental prices helped keep services inflation in check. These declines offset increases in airline fares and several other service categories. (2) CPI inflation (y/y). Headline CPI inflation eased to 3.4% y/y (chart). Core CPI inflation slowed to 2.5% y/y, its lowest reading since March 2021, bringing underlying inflation closer to the Fed's 2.0% objective. While the CPI less shelter remains elevated at 3.4% y/y, it is running at just 1.9% once food and energy are also excluded (chart). Encouragingly, supercore CPI inflation continued to moderate in July. However, at 3.0% y/y, it too remains above the Fed's 2.0% inflation target (chart). In the past, core CPI inflation tended to exceed the core PCED inflation rate by 0.5ppt on average (chart). In recent months, the latter has been running hotter than the former. Other economic data continue to underscore the remarkable resilience of the US economy. Consider the following: (3) Consumer spending. Consumer spending continues to expand at a brisk pace. Redbook same-store sales rose 8.3% y/y in the week ended August 7, well above the 2025 average of 5.8% (chart). Redbook sales increased an average of 8.25% y/y in July. (4) Small business owners survey. Job openings and hiring plans among small businesses improved in July. During the month, 20% of small business owners plan to increase employment over the next three months, the most since October 2022 (chart). In addition, 51% reported no qualified applicants for job openings, the highest since September 2024. The data suggest labor demand remains robust, but hiring continues to be constrained by skills shortages, rising retirements, and slower immigration growth. The percentage of small business owners raising selling prices moderated to 31% in July, and 28% are planning to raise them (chart). Both measures remain relatively high. (5) ADP weekly job growth. For the four weeks ending July 25, private employers added an average of 8,250 jobs per week, according to ADP (chart). This suggests monthly payroll growth of roughly 33,000, a pace that’s likely sufficient to keep the unemployment rate near its current low level given ongoing labor supply constraints.
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