The Federal Reserve left its policy rate unchanged in July, with three participants dissenting in favor of a hike. Prior to the meeting, markets had priced roughly a one-third probability of a rate hike, so the hold was dovish relative to market pricing. In his press conference, Chair Kevin Warsh discussed how inflation has been persistently above-target and emphasized the Fed’s commitment to price stability; this suggests that some policy firming may still be warranted, although maybe not as imminently as markets had previously priced. Unlike other Federal Open Market Committee (FOMC) participants who made public comments ahead of the meeting, Warsh said nothing to signal that depending on how inflation evolves, a rate hike could come as soon as September.
Taken together, the Fed decision and press conference left markets on Wednesday afternoon still pricing 50 basis points of hikes, although with more uncertainty around the timing. Inflation breakevens also adjusted higher along with long-end nominal rates.
In order for markets to mitigate those rate hike expectations, actual inflation likely needs to moderate. We continue to forecast more moderate inflation in the second half of the year, and our base case is that the Fed remains on hold – though elevated energy prices and Middle East tensions skew near-term risks toward higher rates.
A crucial question for the outlook for monetary policy is not simply whether the Fed hikes, holds, or eventually cuts. It is whether the Fed’s tolerance for “2-point-something” inflation is changing under Chair Kevin Warsh. He emphasized that 2% inflation is the objective, but he also noted questions around how inflation is measured and didn’t appear in a hurry to change policy despite his emphasis on the length of time that inflation has remained above target.
Why the Fed passed on a hike in July
Fed officials were divided in the June Summary of Economic Projections over whether conditions might warrant additional tightening this year, but we had not viewed a July hike as especially likely. The data since June bought the committee time: Payroll growth moderated, participation and unemployment were noisy, and inflation data were surprisingly soft.
In recent public comments, several Fed policymakers had conditioned a rate hike on inflation remaining stubbornly elevated – especially New York Fed President John Williams and Fed Governor Christopher Waller, who had framed future hikes as contingent on inflation remaining as persistent as it was in the first quarter of the year. Williams went as far as to say that monthly sequential core inflation of 0.2% for the rest of the year would allow the Fed to hold. Had the Fed hiked in July, we would have read it as something Warsh himself advocated for, alongside a new willingness to surprise markets.
A less hawkish inflation story than core PCE suggests
What policymakers manage must be measured, and inflation data can be complicated in this regard. Year-over-year core personal consumption expenditures (PCE) remained elevated at roughly 3.4% through May – the data the Fed had in hand when it met this week (the June data release from the Bureau of Economic Analysis (BEA) is on 30 July 2026).
Core PCE is the Fed’s standard measure of progress toward its 2% target, but it increasingly looks like an outlier relative to broader measures. The core Consumer Price Index (CPI), median CPI, trimmed-mean CPI, median PCE, and trimmed-mean PCE generally cluster around 2.5%–3.0%, all closer to the Fed’s target.
Much of this gap traces to a small set of categories, chiefly portfolio management services and software. Both have been heavily influenced by AI-related developments – strong equity performance and rapidly rising technology input prices – that may overstate underlying inflation. The BEA has already announced methodological improvements to these deflators that we believe could lower reported PCE inflation by roughly 0.2–0.3 percentage points.
At the same time, labor market conditions and wage growth do not look consistent with a broad-based reacceleration in inflation. On net, we view the economic outlook as consistent with the Fed remaining on hold for the rest of this year, but risks are skewed toward hikes rather than cuts.
Is the Fed’s reaction function changing?
Stepping back, the deeper issue is whether the Fed’s tolerance for persistent 2-point-something inflation is changing under Warsh. Over the past several years, Fed officials appeared to view 2-point-something inflation, alongside labor market normalization, as consistent with a gradual return to neutral interest rates. This is similar to the “opportunistic disinflation” approach of the mid-1990s, when the Fed tolerated above-target inflation and was willing to wait for the next downturn to bring it fully to target.
Some of Warsh’s comments at his first semiannual testimony to Congress, which he echoed at today’s press conference, suggest he may be less willing to allow inflation to remain somewhat above the Fed’s target over time. He emphasized that 2% inflation is the Fed’s objective, and he remarked, “Sixty-three months of inflation above target have been an unfair burden. It has acted as a tax on the American people and businesses. We plan to eliminate that tax. That means we need a regime change in policy and a fresh look at practices, some of which have worked and others that have not.”
Other Fed policymakers could also be evolving away from tolerating 2-point-something. As ongoing geopolitical conflict and supply shocks have the potential to induce more frequent inflation spikes, tolerating inflation in the 2-point-something zone in “normal times” could eventually put upward pressure on inflation expectations. At present, expectations remain well-contained, but recent public comments from Fed officials have argued that the central bank should set monetary policy in a way that ensures inflation expectations remain well-anchored.
If monetary policy strategy is evolving, then inflation stabilizing around 2.5% – the consensus forecast for core PCE in 2027 – may not look like success to Fed officials. It may instead suggest policy is not restrictive enough.
However, Warsh didn’t go as far as to endorse a particular policy response to persistently above-target inflation. He didn’t offer a detailed response to questions around the Fed’s reaction function, and he didn’t appear in a hurry to change policy.
Markets, volatility, and surprises
Despite some market anticipation for a hike, the FOMC’s hold matched our expectations, given how clearly Fed officials had reinforced the June message that further hikes were contingent on additional inflation persistence. (Learn more in our 22 July 2026 Macro Signposts, “When Monetary Policy Surprises Stop Translating.”)
Still, Warsh’s decision to jettison forward guidance is likely to keep front-end volatility elevated and raises the odds of larger future surprises in either direction. Indeed, on Wednesday afternoon, the uncertainty around how the Fed defines its 2% target – and how persistently elevated inflation may (or may not) change monetary policy strategy under Warsh – contributed to a sharp steepening of the U.S. Treasury yield curve, as longer-dated breakeven inflation rose. It’s one example of how markets may respond amid less transparent communication from the Fed chair.
