More Room to Run: The Fed’s Cushion Widens

• Headline CPI fell to 3.4% in July.

• The effective fed funds rate remains at 3.6%.

• The difference means the Fed has room to remain on hold.

July's inflation cooling didn't move the needle on Fed policy, it just banked more flexibility…

On Monday, I laid out why this week's Consumer Price Index ("CPI") report was likely to show further cooling. Falling gasoline prices and an easing composite reading from the Dallas, Kansas City, New York, and Philadelphia Fed districts' prices-received gauges pointed toward the Cleveland Fed's 3.4% estimate for July.

Yesterday, the data confirmed it. The U.S. Bureau of Labor Statistics reported that the non-seasonally adjusted annualized pace of inflation growth fell to 3.4%, landing right where the model pointed and down from June's 3.5%...

That's the direction investors needed to see. After the recent surge higher, an inflation reset lower is much desired relief. Yet, yesterday’s data wasn't a regime change either.

Here's why: with the decrease, the annualized pace of inflation is still below the effective federal funds rate. That means the real rate of interest remains positive, implying policy is restrictive, not accommodative. In simple terms, the Fed doesn't need to raise rates. That means the current setup should support a steady rally in the S&P 500 Index.

But don’t take my word for it, let’s look at what the data’s telling us…

As I noted at the outset, monthly CPI was unchanged in July. The month has typically experienced a 0.1% increase since 2000, meaning this latest result was below average…

The driver was energy. According to the Energy Information Administration, the average price of a gallon of gasoline fell almost 3% last month, below the usual 1% July decrease since 2000…

The Fed has been willing to look through this. So far through August, prices are up 2% compared to the typical decline of 0.5%. Not ideal but nothing like the surge we saw earlier this year. By resisting the urge to react too quickly, policymakers have built themselves a cushion for exactly this kind of shock.

We can see this by looking at the real rate of interest. It’s a measure by which our central can monitor whether the federal funds rate is weighing on inflation growth. A positive number means policy is restrictive while a negative number means policy may be too easy. We can calculate the number by subtracting annualized inflation growth from the effective federal funds rate:

• In May, when inflation was at 4.2% and the effective fed funds rate stood at 3.6%, the real rate was -0.6%.

• That meant our central bank had no rate cut room before it hit neutral.

• With the July inflation result of 3.4%, the real rate cushion is back up to 0.2%.

If we look at the historical data going back to 2000, we notice that the Fed may have more room before it needs to act. According to the numbers, the real rate of interest has averaged -0.6% during that span. In other words, inflation could surge by another three-quarters of a percentage point before policymakers get anxious.

Now let’s look ahead. Prior to the start of the Iran conflict, inflation growth had been averaging about 0.2% per month over the past year. So, I extended that pace over the next 12 months and subtracted it from Wall Street’s expectation that the Fed will raise rates once by the end of this year and again in June 2027…  

The result: real rates could turn negative once more at the end of 2026 but then rebound quickly. By May 2027, they could climb back toward 2.2%, restoring the Fed’s cushion to cut rates again.

As I continue to note, the market isn't irrational, it's early. The road ahead will always be filled with uncertainty — at the moment, nowhere more so than in Iran. But while pundits wait for perfect clarity, disciplined investors prepare for what's next.

A month ago, it seemed like negotiators from the U.S. were headed toward a peace deal with Tehran. But nothing is ever as simple as it seems, and some factions in Iran have begun to feel differently about the terms of the bargain. Still, the two sides remain in contact, and Pakistan recently said they're getting closer to an agreement.

If investors see more constructive dialogue in the coming weeks, that should weigh on global oil prices, cool inflation pressures further, and strengthen the case for rate cuts next year. And that potential for easier access to money should underpin a steady rally in the S&P 500.

Five Stories Moving the Market:

Cisco Systems forecast fiscal 2027 revenue above Wall Street expectations, signaling confidence that strong demand for its AI networking gear will continue to power growth – Bloomberg. (Why you should care – investors were anticipating AI-related demand would comprise a larger percentage of its revenue forecast)

Coherent beat estimates for fourth-quarter earnings and forecast first-quarter revenue and profit above analysts' expectations, betting ​on strong demand for its data center and ‌communications products – Reuters. (Why you should care – the results speak to the strength of demand for data center infrastructure products like optical transceivers)

The Mexican government is pushing the U.S. to lower tariffs on North American automobiles as part of conversations over reworking the U.S.-Mexico-Canada Agreement; the move is a counterproposal to the Trump administration after its push to require more American-made parts in vehicles - WSJ. (Why you should care – Mexico is pushing for zero tariffs on non-U.S. parts compared to the current 25%)

More than 80% of Japanese ​companies use artificial intelligence in only a limited capacity in their operations or not at all, according to a ‌Reuters survey, a trend that could hinder official efforts to boost productivity – Reuters. (Why you should care – the results highlight the AI infrastructure upside potential if enterprises adopt the technology’s use on a more widespread basis)

Prices for Japan’s corporate goods continued to rise at an elevated pace in July, keeping high cost pressure on companies; the measure of input prices for Japanese firms rose 7.2% in July from a year earlier, slightly slower than the revised 7.3% in June – Bloomberg. (Why you should care – the data is likely to keep pressure on the Bank of Japan to raise interest rates)

Economic Calendar:

Earnings – AMAT, DDS, MSGS, TPR, XE

U.K. – GDP for Q2 (2 a.m.)

U.K. – Industrial, Manufacturing Production for June (2 a.m.)

U.K. – Exports, Imports for June (2 a.m.)

Japan – Machine Tool Orders for July (2 a.m.)

Norges Bank (Norway) Monetary Policy Announcement (4 a.m.)

China – New Yuan Loans for July (5 a.m.)

Eurozone – Industrial Production for June (5 a.m.)

U.S. - Initial Jobless Claims (8:30 a.m.)

U.S. - Continuing Claims (8:30 a.m.)

U.S. – PPI for July (8:30 a.m.)

Fed’s Barkin (Richmond, Non‑Voter) Speaks (8:40 a.m.)

Treasury Auctions $25 Billion in 30-Year Bonds (1 p.m.)

Fed's Balance Sheet Update (4:30 p.m.)

RBA’s Bullock (Governor) Speaks (7:30 p.m.)