The Inflation Reset the Market Needed

• Headline CPI fell to 3.5% in June.

• The effective fed funds rate remains at 3.6%.

• The difference means the Fed is in no rush to raise rates.

June's inflation drop didn't change the Fed's calculus, it just bought it more room…

Four and a half months after it started, the stock market narrative is still consumed by the conflict in Iran. A few weeks 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. Some factions in Iran have begun to feel differently about the terms of the bargain. And while the two sides are said to still be in contact, the potential for compromise has gone in reverse.

But while geopolitics continue to dominate the headlines, an important economic data point was released earlier this week. On Tuesday, the U.S. Bureau of Labor Statistics released its Consumer Price Index (“CPI”) data for June. The non‑seasonally adjusted annualized pace of growth fell to 3.5%, down from May’s 4.2%…

From an inflation standpoint, that was the direction investors wanted to see. After the recent surge higher, a reset lower was much needed relief. Yet it wasn’t a regime change either.

Here’s why: with the decrease, the annualized pace of inflation is back 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 contracted 0.3% in June. The month has typically experienced a 0.3% rate of increase since 2000, meaning this latest result was roughly twice as low as average…

The driver was energy. According to the Energy Information Administration, the average price of a gallon of gasoline fell almost 10% last month—far below the usual 1.1% June increase since 2000…

The Fed has been willing to look through this. So far through July, prices are down another 6% compared to the typical decline of 1%. 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. Now, with the June inflation result having dropped, the real rate cushion is back up to 0.1%...

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 then remain on hold through 2027…  

The result: real rates could turn negative once more at the end of 2026 but then rebound quickly. By April 2027, they could climb back toward 1.6%, 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. But while pundits wait for perfect clarity, disciplined investors position for what’s next.

The U.S. and Iran are still talking. That alone is a sign for a deal. If investors see more constructive dialogue in the coming weeks, that should weigh on global oil prices, cool inflation pressures more, 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:

U.S. President Donald Trump is leaning toward expanding U.S. military operations in Iran after days of briefings from top aides, according to U.S. officials; options include stepping up airstrikes, sending ground forces to seize Iranian islands near the Strait of Hormuz and bombing a fortified site that could be used for covert nuclear work – WSJ. (Why you should care – the White House is said to be considering a seizure of Kharg Island and other territory along the Strait of Hormuz)

U.S. Federal Reserve Governor Lisa Cook said she is "prepared to act" if inflation does not soon ​begin to slow; Cook said the risk of persistent inflation now outweighs that of a weakening labor market – Bloomberg. (Why you should care – Cook is a voter and her comments indicate should could vote in favor of a rate hike as soon as the September FOMC meeting)

The Federal Reserve’s Beige Book survey showed signs of a broadly improving economy, with employment on the rise but not straining wage bills, and inflation easing slightly ‌- Reuters. (Why you should care – the report noted price growth was the same or slower in all districts since the last publication)

Federal Reserve Bank of New York President John Williams said interest rates are “well positioned” to bring inflation growth back to the central bank’s 2% target, even as demand driven by artificial intelligence puts upward pressure on prices – Bloomberg. (Why you should care – Williams said policymakers are seeing encouraging signs that inflation growth has peaked and should edge lower in coming quarters)

Cadence Design Systems launched an artificial-intelligence "super agent" that designs printed circuit boards and chip packages, extending ​the company's push to automate more of the engineering process; the ‌tool, called AuraStack, lets engineers describe their goals in plain language, then plans and carries out the work using Cadence's existing software tools to lay out and ​virtually test circuit designs - Reuters. (Why you should care – Cadence said the tool can cut the time to market in half while boosting productivity as much as 15-fold)

Economic Calendar:

Earnings – ABT, GE, ISRG, NFLX, STT, TSM, UNH, USB

U.K. – GDP for May (2 a.m.)

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

Eurozone – Exports, Imports for May (5 a.m.)

U.S. – Retail Sales for June (8:30 a.m.)

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

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

U.S. – Philadelphia Fed Manufacturing Index for July (8:30 a.m.)

U.S. – Business Inventories for May (10 a.m.)

U.S. – NAHB Housing Market Index for July (10 a.m.)

U.S. – Pending Home Sales for June (10 a.m.)

U.S. – Retail Inventories for May (10 a.m.)

Fed’s Logan (Dallas, Voter) Speaks (12:30 p.m.)

Treasury Auctions $44 Billion in 7-Year Note (1 p.m.)

Fed’s Schmid (Kansas City, Non‑voter) Speaks (1:25 p.m.)

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

Fed’s Jefferson (Vice Chair, Voter) Speaks (7 p.m.)