What Moves the Fed, Part I: The State of Inflation

By Scott Welch, CIMA®, Chief Investment Officer & Partner

Reviewed by Carter Mecham, CMA®, IACCP®

As was widely expected, the Fed did not cut rates in its June meeting. As noted in the published minutes following the meeting:

Although swings in net exports have affected the data, recent indicators suggest that economic activity has continued to expand at a solid pace. The unemployment rate remains low, and labor market conditions remain solid. Inflation remains somewhat elevated.

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the long run. Uncertainty about the economic outlook has diminished but remains elevated. The Committee is attentive to the risks to both sides of its dual mandate.

So, with respect to the dual mandate of the Fed to maintain stable price levels and optimize employment, there was no particular reason for the Fed to initiate rate cuts, despite the loud and somewhat vitriolic disagreement from President Trump.

Fed Chair Powell elaborated further in his post-meeting Press Conference.

Our monetary policy actions are guided by our dual mandate to promote maximum employment and stable prices for the American people. At today’s meeting, the Committee decided to maintain the target range for the federal funds rate at 4-1/4 to 4-1/2 percent and to continue reducing the size of our balance sheet. We will continue to determine the appropriate stance of monetary policy based on the incoming data, the evolving outlook, and the balance of risks.

Changes to trade, immigration, fiscal, and regulatory policies continue to evolve, and their effects on the economy remain uncertain. The effects of tariffs will depend, among other things, on their ultimate level. Expectations of that level, and thus of the related economic effects, reached a peak in April and have since declined. Even so, increases in tariffs this year are likely to push up prices and weigh on economic activity.

In other words, the economy, the labor markets, and inflation all remain positive and trending in the right direction, but policy uncertainty (esp. tariffs and the budget) combined with the Fed’s continuing “data dependency” suggested it was not appropriate to cut rates at this time.

Undoubtedly the recent bombing of Iran will only add to that uncertainty until there is better clarity on what the response and ultimate outcomes will be.

In Part One of this multi-part blog series, let’s look at some of the numbers the Fed “watches” when determining its rate policy.

Inflation

Inflation, or more specifically the stability of price levels, is a primary Fed mandate, and its policy for years is that a 2% annualized inflation rate is “stable” – in other words, that is its target.

Where are we today? Three of the commonly followed (or “headline”) metrics are the Consumer Price Index (CPI), the CPI ex-Food & Energy, and the Personal Consumption Expenditures (PCE).

The Fed prefers the PCE metric in evaluating inflation because, unlike CPI, it allows for changes in consumer behavior depending on price levels (e.g., switching from steak to ground beef or from Premium to Regular gas as those respective prices change).

Source: The St. Louis Fed (FRED), through May 2025.

We see that while these metrics are all trending in the right direction, they remain above the Fed’s target 2% annualized level.

Here is the Cleveland Fed’s “Inflation Nowcast” forecast for June. If accurate, this supports the Fed’s decision not to cut rates.

Source: The Cleveland Fed’s “Inflation Nowcast,” as of June 23, 2025. This is a forecast and subject to change as more data come in.

Meanwhile, the Fed’s forecast of longer-term inflation (as measured by the PCE) is also expected to remain above the 2% target rate for at least the next two years.

Source: Yardeni Research and the FOMC, as of June 19, 2025. These are forecasts and will change as additional data come in.

A big part of what drives CPI is “shelter costs” (which represents almost 40% of what goes into calculating CPI via its “owners’ equivalent rent” and “owners’ equivalent rent of primary residence” measurements). Further, those shelter levels are factored into the CPI with a considerable time lag – perhaps 6-9 months. This is one reason the Fed follows but does not necessarily depend on the CPI in determining its current rate policy.

And, in fact, we see that “shelter costs” are falling, suggesting there will be a downward pull on CPI as those lagged results are finally priced into the metric.

Source: The St. Louis Fed (FRED), through May 2025.

This may give the Fed some “wiggle room” to cut rates as we approach the July and September FOMC meetings, and the market in fact is now pricing in at least two rate cuts before the end of the year.

Source: The Atlanta Fed “Market Probability Tracker,” as of June 20, 2025. These are forecasts and subject to change as additional data come in.

Input Prices, Wage Growth, and The Money Supply

Let’s look at three other potential drivers of inflation – input prices, wage growth, and the money supply.

If the input prices of goods and services increase, this may increase inflation if the producers of those goods and services are able to pass through that increased cost to end consumers.

As we write this, this does not appear to be a significant risk. The overall cost of inputs, as measured by the Producer Price Index (PPI), may be rising slowly but remains subdued (following the spike during the Covid-induced supply chain challenges).

Source: The St. Louis Fed (FRED), as of May 2025.

What about wage growth? If employees’ wages are rising faster than the inflation rate, that may also be a source of increased overall inflation, as it is likely to spur increased demand from consumers with more money to spend.

If we compare the headline trends of CPI and the Employment Cost Index, this also does not appear to be a significant source of future inflation. While wages are increasing at a slightly higher level, it is trending in the same direction as the CPI.

Source: The St. Louis Fed (FRED), through Q1 2025.

Finally, let’s look at the money supply. In general, inflation can be sparked by an increase in the money supply, an increase in the “velocity” of that money (how quickly money works its way through the economic system), or both.

What we see is a tremendous spike in the money supply during the Covid years and following the massive fiscal stimulus bills that passed during and shortly after Covid. This is one reason inflation spiked to roughly 9% during the early 2020s. But that appears to be leveling off.

At the same time, money velocity fell precipitously (but unsurprisingly) during Covid and does not appear to be increasing at an accelerating level.

Taken together, the money supply environment does not appear to be a potential driver of inflation at the current time.

Source: The St. Louis Fed (FRED), as of Q1 2025.

The “Known Unknowns”

If simply examining the tangible data, we suggest that inflation is trending in the right direction and by itself would not prevent the Fed from initiating a rate cut regime. And, indeed, that is what is being priced into the market.

But, if we interpret Chair Powell’s press conference narrative correctly, there are a variety of “extraneous” factors influencing the Fed’s decision to leave rates alone in June and steer cautiously as we move through the remainder of the year.

These factors are the “known unknowns” – factors the market is clearly aware of but has no way of anticipating how they will turn out or what effect (or not) they will have on inflation, labor, and the overall economy.

Thes factors include uncertainty over:

1. Tariffs and Trade. It is not so much where the tariff levels eventually land, it is the uncertainty. President Trump is a “tariff president” and so the likelihood is that we will eventually land in an elevated global tariff market regime. But once companies and markets know what those levels are, they can then begin to plan and act accordingly. Thus, while the tariffs themselves may lead to an increase in short-term inflation, they are unlikely to be drivers of long-term embedded inflation.
2. The impending budget bill. This bill is slowly working its way through Congress but, regardless of how it ultimately ends up, it is likely to include items that will encourage faster economic growth combined with a continued “blow out” of both the annual federal debt and the overall federal deficit. Very few people in Washington, including most members of Congress and the Trump administration, have shown any concern or interest over the debt or deficit. The long-term impact on inflation is difficult to predict, but it is unlikely to be a catalyst to lower inflation.
3. Geopolitics. The world is a dangerous place, and even more so following the recent Israel and US bombing attacks on Iran. But the outcome and impact (on, for example, oil prices and the supply chain) of these various global tensions (Ukraine-Russia, China-Taiwan, the Middle East, immigration protests here in the US, etc.) are impossible to predict and, barring an actual war, they also are unlikely to have a long-term impact on inflation.

Summary and Interpretation

In summary, we currently are not overly concerned about rising long-term inflation and would not recommend making any specific reallocations within already diversified portfolios (which likely already have allocations to strategies that help mitigate the impact of inflation).

We continue to recommend diversification at both the asset class and risk factor levels, maintaining portfolio discipline, and maintaining a longer-term time horizon.

Focus on the signals, not the noise.

We hope you find this helpful and, as always, we welcome your feedback and questions.