On Monday, in a speech at the New York Association for Business Economics, Federal Reserve Governor Christopher Waller discussed the U.S. economic outlook and the implications for “monetary policy at a crossroads.” His remarks were more hawkish than many observers expected. Indeed, he’s the first voting member of the Federal Open Market Committee (FOMC) to publicly articulate a conditional path toward rate hikes this year – if we see another “hot” inflation reading.
And on Tuesday, the U.S. Bureau of Labor Statistics (BLS) released the June Consumer Price Index (CPI) inflation data. The headline figure cooled notably, effectively removing a rate hike from consideration at the Fed’s next meeting, while the core inflation figure (excluding food and energy) was unchanged in June. Inflation was soft across both core goods and services categories, suggesting a cooler inflation trajectory in the second half of the year as several temporary sources of upside price pressures fade.
Tuesday is also the first day of Fed Chair Kevin Warsh’s semiannual testimony before Congress, where he reiterated the central bank’s “resolute commitment to restoring price stability” and said that despite the softer inflation report for June, the Fed’s price stability mission has not been accomplished.
Our baseline outlook still sees the Fed on hold through 2026 amid gradually easing price pressures. But Waller’s comments suggest that after a string of firmer Personal Consumption Expenditures (PCE) inflation prints, the Fed now places greater emphasis on responding if inflation surprises sharply to the upside or proves more persistent than expected, regardless of which factors are driving the inflation. And this raises the stakes for incoming inflation data throughout the year.
Waller’s hawkish signal amid a complex inflation story
In his prepared remarks Monday, Waller said, “If we get another hot reading on core inflation this week, then the FOMC will need to consider tightening monetary policy in the near term.” In the Q&A session that followed his speech, Waller’s comments suggest to us that he now requires a sustained period of softer inflation readings to feel comfortable maintaining the current policy stance.
Annualized core CPI has remained in a 2.6%–2.9% range despite considerable volatility in global energy markets following the onset of the Iran conflict earlier this year. However, annualized core PCE inflation has accelerated, moving to 3.4% as of the most recent reading for May – well above the Fed’s 2% longer-run target and the “2-point-something range” we’ve argued that the Fed is willing to tolerate. (PCE is published by the U.S. Bureau of Economic Analysis and is the Fed’s preferred inflation measure. Learn more in our 6 May 2026 Macro Signposts, “U.S. Inflation Measures Tell Two Different Stories.”)
Much of the divergence between the two inflation measures – CPI and PCE – reflects different treatments of software and financial services prices that have greater influence in the PCE measure. Both categories have been supported by strong AI-related investment and equity market performance. Software prices have also been influenced by the sharp rise in memory costs, while portfolio management fees have benefited from strong equity returns.
What’s more, the AI-related inflation has come on the heels of one-time price adjustments associated with tariffs. This has further boosted reported goods price inflation in 2025 and early 2026, offsetting progress made in core services prices – particularly shelter – and keeping overall PCE inflation above the Fed’s 2% target. Trimmed-mean measures of both CPI and PCE have been more subdued, although those measures often lag at inflation turning points.
Supply vs. demand: Which spurs inflation more?
Given these crosscurrents and competing messages from the various inflation measures, the key question is and has been whether the recent reacceleration in core PCE reflects temporary supply-side shocks and one-off price-level adjustments – including tariffs, energy prices, and AI-related demand for specific inputs – or more persistent underlying demand.
The distinction between these sources of inflation is crucial to monetary policy. Policymakers can typically look through temporary supply-driven inflation when expectations are anchored, while they are usually quicker to tighten policy in response to demand-driven inflation. (For details, read our 29 May 2026 Macro Signposts, “Supply Shocks and AI-Related Demand Blur Inflation Signals for the Fed.”) Subdued real consumption growth in the first quarter, which coincided with stronger PCE inflation, adds to the evidence that supply is the primary source of inflation. However, the longer inflation remains elevated, the clearer it becomes that resilient demand is also part of the story.
Over the last several months, persistent upside surprises in core PCE inflation have led us and other forecasters to revise our year-end inflation forecast higher and slightly temper our expectations for Fed easing in 2026. However, we have not gone as far as forecasting rate hikes; we see an unusual mix of supply-related shocks, persistent inflation readings, and still-anchored inflation expectations. Furthermore, labor markets are notably not a source of inflationary pressures. Unit labor cost inflation, which tends to lead core inflation by around one year, is running at levels consistent with the Fed’s inflation target, given 2% productivity growth.
Even so, Waller’s remarks suggest he is increasingly concerned that inflation persistence itself may justify more restrictive policy. In other words, he may prefer the Fed to hike even if inflation turns out to be a supply-side story, to preemptively ensure inflation expectations remain firmly anchored.
Waller also emphasized how the current environment differs from that of 2022, arguing for some caution before tightening. At the same time, he referenced monetary policy rules that imply that the current federal funds rate may be accommodative (perhaps by roughly 100 basis points) relative to prevailing inflation outcomes. It’s a signal Waller appeared reluctant to ignore despite still-well-anchored inflation expectations.
Outlook for inflation and Fed policy through year-end
June’s cooler CPI reading will likely keep Waller – plus the broader group of Fed policymakers who expect inflation to moderate in the second half of the year – on hold while assessing whether the baseline disinflation story remains intact. However, Waller’s comments suggest to us that a monthly core PCE reading north of 0.3% could reasonably qualify as a “hot” print. For context, monthly core PCE inflation has averaged 0.34% for the first five months of 2026, and it would need to average roughly 0.2% per month over the remainder of the year to achieve the FOMC’s median projection of 3.3% for the full year.
The next PCE data release is on 30 July 2026 (the day after the Fed’s next policy decision). Based on the latest CPI data – the source data for a majority of PCE inflation categories – we estimate PCE will print at 0.2% for the month of June, a reading that is soft enough to provide the Fed with a lot more time to wait for more data. We expect inflation to continue on a more moderate path in the second half of the year as tariff- and energy-related price adjustments fade. Reported inflation has also historically tended to be firmer in the first quarter and softer later in the year – a phenomenon economists call residual seasonality.
We expect changes in how certain PCE price categories are measured will also reduce reported PCE inflation: Annual benchmark revisions to the National Income and Product Accounts, due to be announced in September, will narrow some of the recent divergence between PCE and CPI inflation by reducing the measured impact of AI-related categories – portfolio services and software inflation will likely be revised down.
Bottom line
For a host of reasons, we – like most forecasters and the majority of the FOMC – expect inflation to moderate in the second half of the year and the Fed to remain on hold. However, Fed communications are increasingly preparing markets for the possibility of renewed tightening should inflation fail to cooperate.
As of the June meeting, the FOMC appeared roughly split between members favoring a baseline of additional tightening and those who favor remaining on hold, with Warsh (who did not issue his own projections) potentially representing the swing vote. Waller at that time was in the “hold” camp, so if his more hawkish signals align with the views of other centrists (Governor Powell, perhaps?), then it’s possible even a single significant upside inflation surprise could tilt the balance toward a rate hike.
Nevertheless, as we’ve said previously, this is not 2022 for a number of reasons. Exceptionally large fiscal stimulus to counter the pandemic’s economic damage, historically tight labor markets, and deeply negative real rates all contributed to the post-pandemic global inflationary surge and the need for aggressive central bank tightening. Today, labor markets are not a source of inflationary pressures, the government isn’t transferring trillions of dollars to the private sector, and – importantly for bond investors – real yields are much higher.
Indeed, elevated starting yields mean that even if rates were to rise, there is currently a significant income cushion to help offset potential price losses. Furthermore, rising rates that help keep inflation expectations anchored may also mean that intermediate and longer-dated rates are more resilient in the face of some policy firming. And in the event that inflation does cool, or the economy performs worse than expected, the capital appreciation potential makes bonds an attractive investment across a range of scenarios.
