Fed report to Congress sees ‘stepped up’ inflation in the spring
The most important line in the Federal Reserve’s July Monetary Policy Report is unusually direct:
Measures of consumer price changes “began trending up last year and then stepped up further this spring.”
That is a firmer characterization than simply saying inflation remains elevated. The Fed is acknowledging that the inflation picture has deteriorated, with headline PCE inflation rising to 4.1% in May from 2.5% a year earlier and core inflation climbing to 3.4% from 2.8%.
The report attributes the increase to a combination of tariffs, the energy shock following the outbreak of conflict in the Middle East and unusually strong demand for high-tech equipment associated with artificial intelligence. Energy prices rose 24% from a year earlier, but this is not solely an oil story. Core goods inflation accelerated to 2.4% from 0.6%, while prices for computers, software and electronics were pushed higher by demand for semiconductors and data-centre infrastructure.
There are still some encouraging details. Housing-services inflation slowed to 3.2% from 4.1%, and the Dallas Fed’s trimmed-mean PCE measure eased to 2.4%. Longer-term inflation expectations have also remained broadly anchored. However, shorter-term expectations have moved higher, and core non-housing services inflation remains firm at 3.9%.
The language explains why the Fed has moved so sharply away from an easing bias. The median projection now puts the fed funds rate at 3.8% at the end of 2026, compared with 3.4% in March. That effectively points to a possible 25-basis-point increase from the current 3.50–3.75% range. The report also notes that several standard monetary-policy rules prescribe a policy rate slightly above the current range.
The economy is solid, but the strength is narrow
The Fed continues to describe economic activity as expanding at a “solid pace,” though the underlying details are less impressive than that phrase suggests.
GDP grew at a 2.1% annualized pace in the first quarter, but private domestic final purchases—a better measure of underlying demand—rose only 1.7%. Gross domestic income increased just 1.2%. Consumer spending slowed further to a 1.3% annualized pace through the first five months of the year.
The real growth engine is capital spending. Business fixed investment surged at an 11% annualized pace in the first quarter after rising 5½% in 2025. Data-centre construction, high-tech equipment and software accounted for most of the strength. Manufacturing output has also improved, led by computers, electronics, metals and machinery.
Outside of AI-related investment, the picture is considerably softer. Spending on offices and manufacturing structures has been weak. Housing activity remains stagnant, existing-home sales are near historically low levels and single-family housing starts have been trending down. The Fed puts the prevailing 30-year mortgage rate at 6.4%, while most existing borrowers remain locked into rates below 4%.
The report therefore describes an economy increasingly dependent on an extraordinary technology investment cycle. AI is supporting growth and productivity, but it is also adding to near-term inflation through demand for energy, metals, semiconductors and imported equipment.
Real consumer spending increased at just a 1.3% annualized rate during the first five months of 2026, after slowing to roughly 2% in 2025.
It identifies four pressures:
- slower wage growth;
- much lower immigration and population growth;
- higher prices resulting from tariffs;
- elevated gasoline prices.
The labour market is stable because supply growth has collapsed
The unemployment rate was 4.2% in June and has changed little since last summer. Layoffs remain subdued, job openings have stabilized and private payroll growth improved to nearly 100,000 per month in the second quarter.
Ordinarily, that pace of hiring would look soft. However, immigration has slowed sharply and population aging continues to reduce labour-force participation. With labour supply barely growing, modest job creation is enough to prevent unemployment from rising.
Productivity is another source of resilience. Business-sector productivity has grown at an average annual rate of 2.1% since late 2019, compared with 1.5% during the previous business cycle. The Fed says current wage growth is approximately consistent with 2% inflation over time when those productivity gains are taken into account.
Even so, aggregate wages failed to keep pace with the latest rise in consumer prices with real wage growth turning negative. Household finances remain healthy overall, but there are signs of strain: the saving rate has fallen to 3.9%, auto-loan delinquencies have risen among lower- and moderate-income borrowers and consumer sentiment remains weak. Small businesses are also relying increasingly on expensive revolving credit.
Bottom line
The report depicts an economy that is slowing at the household level but remains supported by AI investment, productivity growth and a stable labour market. That gives the Fed room to concentrate on inflation.
The June projections reinforce the point. The Fed lowered its 2026 growth forecast only modestly, to 2.2% from 2.4%, while lifting its headline inflation forecast to 3.6% from 2.7% and its core forecast to 3.3% from 2.7%. At the same time, the projected unemployment rate was lowered to 4.3%.
The report’s repeated commitment that the Committee “will deliver price stability” leaves the door open to a hike should the spring inflation step-up prove persistent.
This article was written by flc97fe4880a4b454993821fe0b770a597 at investinglive.com.