The inflation temperature is about to rise. It should be a low-grade fever, triggered by tariff impacts but mitigated by low energy prices, declines in shelter inflation and global economic sluggishness. But it should also linger well above the Fed’s 2% target, as the initial impact of tariffs is supplemented by the effects of a weakening dollar, a lack of labor supply and fiscal stimulus in the first half of 2026. It could, of course, be further sustained by another round of fiscal stimulus before the mid-term elections.
In a still-growing economy, this persistent inflation overshoot ought to be enough to convince the Fed to maintain interest rates at current levels, which are not restrictive by historical standards. However, given political pressure, we now expect them to cut the federal funds rate by 50 basis points this year and 75 basis points next year.
Such a move probably won’t, in itself, boost economic growth or raise inflation although it could further inflate home prices and asset prices more generally. Moreover, while it might temporarily cut borrowing costs for the government, it could worsen the long-run fiscal outlook by enabling the federal government to run even bigger primary deficits and eroding investor confidence in the Fed’s determination to hold inflation in check.
For investors, the persistence of inflation would limit potential capital gains on high-quality bonds, even with the Fed easing or in a weaker growth scenario. It could also, in time, put further downward pressure on the dollar. This underscores the need to broaden the diversification of portfolios to include alternative and international assets.
The Tariff Impact – Updated
As has been the case many times this year, we have updated our forecasts to incorporate changes in tariffs. As of today, we estimate an average static tariff rate levied on imported goods of 17.4%, assuming no change from last year in the share of imported goods coming from individual countries.
In reality, though, importers have switched their purchases to try to reduce tariff impacts. For example, imports from China, which now face a 39.7% average tariff rate, have fallen from 13% of total goods imports in 2024 to just 8% in the second quarter of this year, while the share of imports from Mexico, which are taxed at an 11.6% rate, has risen from 15% to 16% over the same period.
For this reason, if there were no further changes to tariff rates, we assume that the average effective tariff rate on imported goods would peak out at 14.4% rather than 17.4%. This compares to an average effective tariff rate in 2024 of 2.4%. It is also worth noting that tariff revenues, while rising quickly, are still lagging behind the numbers suggested by even these effective rates. This is likely because higher tariffs only apply to goods that had not already been shipped when the new rates came into effect.
There is a further delay between when tariffs are paid by importers and when retailers charge consumers higher prices on newly imported goods. Finally, foreign producers could simply cut their prices or U.S. retailers and wholesalers could absorb some of the higher costs to avoid fully passing them on to consumers.
On this last point, because importers pay the tariffs first, they appear to be shouldering most of the cost of the tariffs so far. However, in the long run, any assumption that tariff costs will be absorbed by foreign producers or U.S. retailers presupposes that these are high-margin businesses that can actually do so. More likely, most of the cost will, eventually, be passed on to consumers.
To be on the conservative side, for now, we assume that 50% of the cost of the tariffs are passed through to consumers, three months after the new rates take effect, phased in over a further three month period. Under this assumption, tariffs would still add 1.0 percentage points to the year-over-year growth rate of the consumption deflator in the fourth quarter. This bump to year-over-year inflation would be sustained through the second quarter of 2026, fade in the second half of 2026 and peter out in the first quarter of 2027 – assuming that tariff rates don’t change in a meaningful way from today’s levels.
It is important to underscore that there is plenty of uncertainty around these projections as we have no recent precedent for tariffs of this scale. We will, of course, adjust these estimates as we get more information on steady-state tariff revenues, import prices and consumer prices.
Temporary Offsets
Even as tariffs increase inflation, there are some offsetting factors, at least in the short run:
- Shelter inflation, which has a 35% weight in the overall CPI, tends to lag marketplace reality. It peaked at 8.2% year-over-year in March 2023 and, by June of this year, was still 3.8%. New lease rates on rental property rose 2.9% year-over-year in June according to Zillow and we expect the government’s measure of rents and owners’ equivalent rent to slowly converge with this over the next 18 months, reducing shelter inflation to 3.0% by December 2026.
- Energy, which has a 6% weight in CPI, saw a 0.2% year-over-year decline in June, as lower crude oil prices more than offset the impact of rising electricity prices. Futures markets see WTI oil prices falling from $68.40 in July of this year to $61.50 by the end of 2026, as OPEC increases production and prospects improve for an end to the Russia-Ukraine conflict. However, it should be recognized that, in real terms, crude oil prices are now very low relative to recent history, increasing the risk of an upside surprise.
- Airline fares are also very low currently, falling 3.5% year-over-year in June. That being said, as in the case of oil, there is probably a greater chance of some shock boosting rather than depressing airline fares from these levels in the year ahead.
What Could Cause Inflation to Linger
In arguing for near-term easing, two Fed governors recently suggested that tariff inflation will likely be temporary. This is a reasonable supposition. However, there are other factors that could cause inflation to linger.
- First, the trade-weighted dollar has fallen by 7% year-to-date, which, all other things being equal, would tend to increase import prices. While overall import prices have been restrained by falling fuel prices, this lower dollar will impede any potential reduction in non-energy import prices that might have occurred if foreign producers were planning to absorb some of the cost of higher tariffs.
- Second, wage growth is relatively stable at 3.9% year-over-year in July. However, the immigration crackdown, by tightening labor supply, should, at a minimum, hold wage inflation at this level and could boost it.
- Third, according to CBO estimates, the OBBBA will reduce individual income taxes by $24 billion this fiscal year and $131 billion next fiscal year, relative to the current policy baseline. This reflects tax breaks on auto loans, overtime, tips and state and local taxes as well as increases in the standard deduction, the child tax credit and an enhanced senior deduction. Most of these breaks are back-dated to January 1st, 2025, setting up the potential for a bumper crop of income tax refunds in early 2026 that could boost both consumer spending and inflation.
- Finally, it is quite possible that Congress will introduce further fiscal stimulus in late 2025 or early 2026 to make sure economic growth is strong going into the mid-term elections. This could, of course, also sustain higher-than-target inflation.
Given all of this, (although ignoring, for now, the possibility of further tariff increases or further fiscal stimulus), we expect year-over-year CPI inflation to rise from 2.8% in July to 3.5% by 4Q2025, before drifting down to 2.8% by the fourth quarter of 2026. We expect year-over-year consumption deflator inflation to rise from 2.6% in July to 3.3% in 4Q2025, before drifting down to 2.4% by 4Q2026.
The Other Inflation
Above-target inflation should be sufficient reason for the Fed to keep short-term interest rates where they are, given continued economic growth and an unemployment that that is exactly at the Fed’s 4.2% long-run expectation. However, there is another important reason to avoid super-low interest rates and that is asset prices.
Much has been said about rising consumer prices in recent years, with the CPI increasing by 26% in the six years ending in June 2025. However, it is worth recognizing that over the same period, the median price of an existing single-family home has climbed by 51% while the S&P500 has risen by an astonishing 111%. While super-low interest rates over much of this period, have greatly increased the wealth of American households, they have also pushed home prices to unaffordable levels for many young families while generating asset bubbles that could well end badly. While not directly part of their mandate, the Fed would be well advised not to add further fuel to already bubbly asset inflation.
Finally, the Fed has no good reason to limit borrowing costs for the federal government. While it may seem attractive to lower interest costs that now account for more than half of deficit spending, the real problem with deficits is not the market’s unwillingness to finance it but the public’s unwillingness to elect representatives who are serious about tackling it. Lower short-term interest rates could well lead to higher long-term interest rates almost immediately, if investors concluded that the Fed was willing to accept higher inflation in the long run to mollify the administration in the short run and that monetary policy would not act as any real check on fiscal largesse going forward.
The Insidious Danger of a Close-Call Capitulation
All of this being said, we do expect the Fed to cut rates by 25 basis points in September and a further 25 basis points in December.
Following the resignation of Federal Reserve governor, Adriana Kugler, the President has nominated the head of the Council of Economic Advisors, Stephen Miran, to serve out the remainder of her term. It is not clear, at this stage, whether the Senate could confirm Miran quickly enough to allow him to participate in the September FOMC meeting. However, even without clarity on his participation, futures markets have priced in almost a 100% probability of a 25 basis point rate cut at that meeting. They have also priced in at least one more cut in 2025 and three in 2026, cutting the federal funds rate down to just over 3% by the end of next year.
While the outlook for inflation and unemployment don’t justify this easing, we expect the Fed to follow through on it anyway. Their rationale may be that it is a close call either way, and, with inflation expected to fall eventually, there may not be much harm in cutting rates preemptively.
This is a dangerous logic. Monetary policy is a long series of close calls and throughout its history, the Fed has made these calls in accordance with its mandate from Congress and, as Jay Powell frequently puts it, solely in service to its public mission. If it strays from this, even in a close call, and even to try to ward off a more direct attack on its independence, it risks further eroding trust in the U.S. financial system and thus, U.S. financial assets and the dollar.
Given this risk, and the probability of continued, somewhat elevated inflation, it still makes sense for investors to broaden the diversification of their portfolios to include some alternative assets, particularly those that can best offset inflation, as well as international assets denominated in foreign currencies.