Connor Hare

It has been one week since the full complement of reciprocal tariff policies went into effect. Those tariffs will not have an influence on the economic data for a few months, but the tariffs that prevailed through the first half of the year continued to show up in the July inflation readings released this week. This included the CPI and PPI, both of which showed signs of rising price pressures that are expected to trend higher over the coming months with the new tranche of tariffs now in effect. Largely undeterred, equity markets continued to probe record highs, with the S&P 500 rising 1.0% on the week and notching a double digit return year-to-date (Chart 1).

The first inflation report we received on Tuesday showed consumer price growth accelerating in July, with the annual percentage change in core CPI rising above 3% for the first time since February. This was driven by stronger core goods prices, largely related to higher tariff passthrough, while core services inflation also trended higher (Chart 2). Producer prices, which we received on Thursday and measure the prices charged by U.S. businesses, also began to trend notably higher in July with the monthly change hitting a 3-year high. This likely suggests that businesses are shifting to pass on more of the higher costs associated with tariffs to consumers after largely absorbing the costs in the first half of the year. Moving forward, with the effective U.S. tariff rate nearly 10 percentage-points higher after last week’s reciprocal tariffs came into force, inflationary pressures are expected to remain elevated through the second half of the year.

The Federal Reserve has been acutely attuned to these developments, with the central bank remaining on hold since the start of the year. Although a few Federal Reserve officials have advocated for rate reductions, the balance of the FOMC continues to voice caution regarding the uncertainty surrounding the outlook for inflation and the economy. The officials we heard from this week, including regional Fed presidents Schmid (Kansas City) and Goolsbee (Chicago) who are voting members of the FOMC this year, noted that caution was still warranted. Market pricing fluctuated this week, but currently has 90% odds for a rate cut in September. The annual Jackson Hole Symposium next week will be watched closely after this week’s inflation reports for any signs on the leanings of officials in the run-up to the next Federal Reserve decision in one month.

On a more positive note, retail spending appeared to remain healthy in July, growing 0.5% month-on-month. However, July also had Amazon’s multi-day Prime day event which tends to boost sales activity. A non-outsized reading could suggest that consumption is beginning to slow in line with the downward revisions to the labor market recorded in the second quarter. This is part of the reason why Federal Reserve officials have continued to advocate for caution, noting that it will take time to properly assess the state of the U.S. economy amid the fog of various shifts in trade policy.

Next week, we’ll receive the FOMC meeting minutes for July as well as the July reading for PCE inflation which should help formulate expectations for September’s Fed meeting. With trade policy uncertainty waning gradually, the attention of markets will shift back towards the Fed.

It was a quiet week on the economic data calendar, but with earnings season in full swing, further trade announcements, and several Fed officials out speaking, there were no shortage of developments for investors to sift through. To say this earnings season has gone better than expected would be an understatement. At this point, over 80% of companies included in the S&P 500 have reported second-quarter earnings. According to Reuters, after factoring in analysts’ forecasts for the remaining 20%, profit growth is tracking close to 12% annualized. That’s more than double what was expected just one month ago, and has without question been a driving force sustaining the recent strength in equities. At the time of writing, the S&P 500 is up 2% on the week and 8.5% on the year. Meanwhile, term-yields climbed a bit higher on the week, even after President Trump appointed Stephen Miran to complete Adriana Kugler’s brief remaining term on the FOMC, and more dovish leaning Governor Waller was reported to be the frontrunner for Fed Chair.

But we would argue that the run in equity markets this year is built on a shaky foundation. Inventory stockpiling and a haphazard rollout of the administration’s tariff policies meant that many businesses were able to circumvent or significantly limit tariff exposure last quarter. But that’s not going to continue. As of August 7th, dozens of trading partners now face significantly higher tariffs as per the Executive Order released by the White House on July 31st. By our estimates, the current effective tariff rate in the U.S. is around 19%, or the highest level since 1933 (Chart 1).

Over the near-term, it’s very likely that the U.S. tariff rate pushes even higher. The Trump administration singled out India this week, threatening an additional 25% tariff on August 27th and hinted at further tariffs on semiconductors – potentially as a 100% – and pharmaceuticals over the coming weeks.

While the economy had demonstrated unwavering resilience earlier in the year, more recent data has shown that ground is starting to shift. This week’s ISM services report provided further evidence that the economy is slowing, with the services index slipping to 50.1 or just barely remaining in expansionary territory. Details of the report came with plenty of ‘stagflationary undertones’, with new-orders, business activity and employment all turning lower, while the prices paid sub-component remained near its cyclical high.

The shift in economic data has led Fed officials to pivot on their communication, with regional Fed President’s including Neel Kashkari and Mary Daly – neither of whom are voting members – to suggest that rate cuts are coming in the months ahead. Meanwhile, Governor Cook characterized last week’s tepid jobs report as ‘concerning’ and noted that the significant downward revisions to the May/June figures, which were some of the largest on record, are ‘typical of turning points in the economy’ (Chart 2). Next week’s CPI inflation data will shed more light on the extent of tariff passthrough, but even that is feeling somewhat backward looking given this week’s reset on tariff rates. Ultimately, the weakness in the labor market cannot be ignored and (in our view) solidifies the case for a September rate cut.

Investors appear to be taking the latest trade escalation in stride. U.S. equity markets briefly hit a new record high on Thursday, but then retraced on Friday in response to President Trump’s tariff threats on Canada. The S&P 500 looks to end the week 0.4% lower but is still up 6% on the year. Meanwhile, longer-term Treasury yields were a touch higher on the week, despite another healthy 10-year Treasury auction on Wednesday. As of the time of writing, the 10-year sits at 4.41%.

But the recent calm that has descended over global financial markets feels eerily tenuous, particularly amidst the ongoing shifts in trade policy and Q2 earnings season set to kickoff next week. Last quarter, much of the guidance companies were providing was purely speculative, as tariff policies were only in the early stages of being rolled out and were also changing on an almost daily basis. However, now that the tariffs have been in place for some time, companies are likely in a better position to gauge their impact and provide updates to earnings guidance for the second half of the year.

With the inflation impact so far proving more subdued than previously expected, there’s been a growing divide among FOMC members on when to resume rate cuts. Minutes from the June 17-18 meeting released on Wednesday showed that while most committee members favor delaying cuts until there’s more certainty on the inflation and labor market impacts, recent speeches suggest that two board members – Governor Waller and Bowman – support cutting rates as early as July.

This puts next week’s CPI inflation release under the spotlight. We expect the June CPI report to show inflation having strengthened, with both goods and services price pressures having heated up relative to May. But at this juncture, the uptick is unlikely to unnerve policymakers, particularly with inflation expectations remaining well anchored. According to the New York Fed’s Survey of Consumer Expectations, one-year ahead inflation expectations fell to 3.0% in June – returning to its pre-tariff levels (Chart 2). In our view, this supports the Fed remaining on the sidelines until at least September.