“Let it be, let it be
Let it be, yeah, let it be
Whisper words of wisdom, let it be”
(From “Let it Be” by the Beatles, 1970)
This three-part blog “mini-series” will focus on the Fed – what it looks at and the decisions we think it will make as we move through 2026 and into 2027. In Part I we focused on one of the Fed mandates – the labor market. Here in Part II, we focus on the other Fed mandate – price stability or inflation.
By Scott Welch, CIMA®, CEPA®, Chief Investment Officer & Partner
Reviewed by Carter Mecham, CMA®, IACCP®
As we discussed in Part I of this blog “mini-series” on “What Moves the Fed,” there does not appear to be any indication within the most recent labor statistics to catalyze the Fed to move one or another with respect to its rate policy.
And, in fact, we suggested the next Fed move might be a rate hike.
Why do we believe that? Very simply, because of the trends in inflation.
The May edition of the Federal Reserve System “Beige Book” summarizes the issue very well.
Prices increased at a moderate to strong pace overall, with most Districts reporting higher inflation than the previous report. Districts noted that energy-related costs tied to the conflict in the Middle East were the primary driver of inflationary pressures, with spillovers into shipping, packaging, groceries, and fertilizer.
Non-labor input costs continued to rise faster than selling prices, contributing to broader concerns about margin compression.
The ability to pass on higher costs remained mixed across sectors, particularly among consumer-facing firms. Consumer uncertainty and concerns about fuel prices impacting households were noted by several Districts.
So, with this as a backdrop, in Part II of this multi-part blog series, let’s look at some of the inflation 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.
Keep in mind this suggests that the Fed thinks it is appropriate for inflation to grow at 2% per year in a healthy economy. Which is fine as a target, but remember that we suffered through a period of 9% inflation just a few years ago, and that those higher prices are “baked in” to current price levels.
In other words, The Fed is targeting a 2% increase per year on top of the 9% increase in prices a few years ago. It should not be surprising, therefore, that many consumers are not “feeling” the drop in the annual inflation rate from 9% down to its current level of almost 4%.
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), 5-year data through April 2026.
We see that these metrics are all trending in the wrong direction and remain above the Fed’s target 2% annualized level. The Fed takes out Food & Energy prices to arrive at a “core” inflation number, because those prices tend to be quite volatile, especially now with the ongoing Iranian conflict.
But since most consumers spend a healthy chunk of their monthly budget on food and gas, taking out those prices results in largely meaningless “core” inflation metric as far as they are concerned.
Here we see a comparison of the headline CPI number with the change in prices of food and energy.
Source: The Bureau of Labor Statistics, data through April 2026.
To highlight the impact of higher energy prices, we see that gas in the US is averaging almost $4.25 per gallon, or $1.10 more per gallon than 12 months ago. If this continues, it may have a significant impact on the mid-term elections in November.
Source: Bloomberg and the AAA, as of June 4, 2026.
Here is the Cleveland Fed’s “Inflation Nowcast” forecast for June. If accurate, this supports the Fed’s recent decisions not to cut rates and, in fact, would lend support to a Fed rate hike in the coming months.
Source: The Cleveland Fed’s “Inflation Nowcast,” as of June 3, 2026. This is a forecast and subject to change as additional data come in.
These numbers will change, of course, depending on how long the war with Iran continues and how it long it takes after the conflict ceases for global supply chains to re-normalize. Here in the US, we benefit from being largely energy independent, but we are not immune to global price changes – we may just not feel them for a lagged period of time.
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 March 31, 2026. 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”, until recently, were falling, suggesting there will be a downward pull on CPI as those lagged results are finally priced into the metric. This may give the Fed some “wiggle room” with respect to rate policy as we approach the July and September and FOMC meetings.
Source: The St. Louis Fed (FRED), 5-year data through April 2026.
Pulling inflation in the other direction, however, are input prices, as measured by the All-Commodity Producer Price Index. As quoted from the Fed above, the ability of producers to pass through higher input prices to consumers is “mixed across sectors, particularly among consumer-facing firms.”
This means either higher prices for consumers or pressure on operating margins for producers.
Source: St. Louis Fed (FRED), 5-year data through April 2026.
It is worth noting that producer prices were trending upward even without the recent spike in food and energy prices (blue line in the following chart).
Source: Bureaus of Labor Statistics, data through April 2026.
Wage Growth and The Money Supply
Let’s look at two other potential drivers of inflation –wage growth and the money supply.
Let’s start with 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.
On a stand-alone basis and according to ADP (a national payroll and HR firm), wages in the US are currently increasing between 4%-6% per year.
Source: ADP and the Daily Shot, as of June 4 2026.
That seems like a nice increase in wages, but it needs to be compared historically to changes in the underlying inflation rate. Even if wages are currently increasing faster than the headline inflation levels, that does not mean workers have “made up” for the loss of purchasing power during the 9% inflation era of a few years ago.
What we see in the following chart is (a) workers losing significant purchasing power in the high inflation years of 2021-2023, followed by (b) a “catch up” period from 2023-2026, when wages grew faster than inflation (which does not necessarily translate into regaining significant purchasing power, and (c) here in 2026 inflation has once again overtaken wage increases.
Source: The St. Louis Fed (FRED), 5-year data through April 2026.
It is no wonder that, despite seemingly positive “headline” economic news, many consumers are not feeling optimistic about their personal futures.
Source: The Conference Board, the University of Michigan, and dShort.com, data as of May 2026.
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. We see, however, that the money supply seems to have returned to growing at a more historically normal rate.
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), 10-year data as of Q1 2026.
The “Known Unknowns”
Even if we simply examine the tangible data, we see that inflation is trending in the wrong direction.
But, if we interpret the recent Fed “Beige Book” comments correctly, there are a variety of “extraneous” factors influencing the Fed’s decision to leave rates alone in April (and most likely 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:
- Tariffs and Trade. With the Supreme Court overturning many of President Trump’s tariff initiatives, this issue has fallen off “the front page” to some degree. But in recent days, President Trump announced new tariffs of up to 12.5% on imports from 60 economies based on their use of “forced labor.” In other words, he is trying to bump up tariffs again positioned as a humanitarian response. It is too early to know how or if these new tariffs will be implemented, enforced, or once again overturned in court. But is an issue that simply will not go away.
- Geopolitics. The world is a dangerous place, with wars continuing to rage in Ukraine, the Middle East, and Iran. The outcome and impact (on, for example, oil, fertilizer, helium, and other essential resources, as well as the global supply chain) of these various global tensions are impossible to predict but, the longer they go on, the higher the probability they will have to negatively affect inflation.
Summary and Interpretation
In summary, inflation is the primary issue facing the US and global economies, and current trends are not moving in a favorable direction.
The current level of inflation is not overly problematic, especially if it is short-lived and returns to its downward trajectory once (should) the Iranian conflict ends and the Strait of Hormuz is once again open for passage of oil and other essential resources. But as we write this, that remains a dramatic “unknown.”
Given this uncertainty we do not recommend making any specific reallocations within already diversified portfolios – our own recommended portfolios are well positioned to mitigate against and, in some cases, even benefit from increases in inflation.
As we emphasized in Part I of this mini-series, 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.