Cooling inflation supports the case for Fed patience

Key Takeaways:

• Inflation has displayed an encouraging trend. Markets breathed a sigh of relief last week, with some stock indexes finding new all-time highs, once again, as inflation resumed its downward trend, dispelling some concerns that inflationary pressures may become increasingly broad-based and persistent, for now.
• For the Fed, patience may remain a virtue. With the Federal Reserve's next policy meeting not scheduled until mid-September, upcoming labor market and inflation reports will likely be key in shaping policy expectations. However, we believe recent indications of a steady labor market and moderating inflation may give policymakers additional room to remain patient.
• Key fundamental drivers for markets remain a source of strength. Strong earnings expectations across a range of sectors, healthy economic momentum, and steady consumer spending continue to underpin equity markets, in our view, helping create a favorable backdrop and potential opportunities for disciplined investors.
• Rather than positioning for a single market outcome, emphasize diversification with an opportunistic lean toward stocks. While inflation has moderated, the path back to the Fed's target may not be perfectly smooth, reinforcing the value of diversification over making concentrated bets on any one inflation scenario. Given a constructive economic backdrop, we favor an overweight to a diversified mix of U.S. and international equities to help capture opportunities linked to both AI-driven innovation and broader economic growth.

Following a stretch packed with key economic data, central bank meetings, and quarterly corporate earnings reports, last week brought a noticeably lighter calendar. The quieter backdrop was reflected in market behavior, as the CBOE Volatility Index—often referred to as the market's "fear gauge"—revisited its 2026 lows, despite the evolving headlines surrounding diplomatic efforts in the Middle East.

The week was not without a headliner, however: inflation. Encouragingly, the week brought good news for investors on this front, helping the S&P 500 and small-cap indexes find new all-time highs. What's more, we believe the broader economic backdrop remains supportive for markets, as well, potentially rewarding investors who maintain discipline.

Inflation has displayed an encouraging trend

Investor attention has remained firmly focused on inflation, and for good reasons. The combination of higher energy prices, tariffs, and strong capex investment related to artificial intelligence has fueled concerns that price pressures could become more broad-based and persistent, potentially prompting the Federal Reserve to resume rate hikes to stay ahead of inflationary risks. However, the range of inflation indicators released over the past week displayed encouraging trends from different perspectives:

• Consumer inflation eased: The consumer price index (CPI), which tracks changes in the prices consumers pay for a basket of goods and services, resumed its gradual downward trend following what was largely an energy-driven uptick earlier in the year. From a year ago, headline CPI rose 3.4%, down from last month's 3.5% reading and in line with expectations. Excluding the more volatile food and energy categories, core CPI rose 2.5%, down from last month's 2.6% reading, also in line with expectations. Year-over-year inflation for the services category, which makes up around 60% of the CPI basket, moderated to 3% from 3.2%, helped by slower wage growth and housing disinflation, while goods inflation was unchanged at 0.8%.
   
• Wholesale inflation eased: Producer price index data (PPI), which measures price changes received by producers and could provide an early indication of inflation pressures that may ultimately filter through to consumers, came in cooler than expected. Headline PPI rose 4.7% from a year ago, down from last month's 5.5% reading. Removing food and energy, core PPI moderated to 4.2%, from 4.7% in June.
   
• Inflation expectations remained contained: Market- and survey-based measures of inflation expectations help provide a more forward-looking view of inflation and/or could indicate potential consumer behavior. Based on the pricing of 10-year Treasury Inflation-Protected Securities, bond markets reflect an expectation for CPI inflation to remain contained, potentially averaging around 2.2% over the next 10 years. Moreover, these expectations have held within a relatively small range for several years and are near the lower end of their 2026 range, suggesting temporary price shocks are unlikely to become more structural or long-term in nature.

Bottom line: Inflation remains elevated, creating a headwind for household budgets and potentially economic growth. In addition, uncertainty surrounding diplomatic efforts in the Middle East and the potential impact on energy supplies remains a key upside risk. However, recent data suggest inflation pressures have not re-accelerated, in our view, with second-round effects appearing contained for now. We also expect softer labor market conditions and moderating housing inflation to continue supporting overall disinflation in the months ahead, which may be further supported by easing geopolitical tensions and stabilizing energy markets as negotiations in the Middle East progress.

For the Fed, patience may remain a virtue

While recent data showed encouraging trends, inflation remains persistently above the Fed's 2% target, indicating the central bank may have more work to do to achieve its longer-term objective. And with labor markets slow but steady, the Fed has placed a greater focus on the inflation side of its dual mandate, increasing the importance of last week's data releases in shaping policy expectations.

At its July meeting, nine of the Fed's 12 voting policymakers opted for patience, choosing to keep rates unchanged rather than to move toward a more restrictive policy stance at the time. With the Fed's next policy meeting not scheduled until mid-September, policymakers will have the benefit of several additional labor market and inflation reports before making their next rate decision. However, recent indications of a steady labor market and moderating inflation have increased the likelihood that patience may, once again, win the vote, in our view.

Bottom line: As investors closely monitor incoming inflation data, shifting expectations for monetary policy could be a source of periodic volatility across stock and bond markets, particularly given limited communications from Fed officials regarding its policy expectations and future guidance. However, currently, market expectations reflect a steady path for monetary policy, with only one rate hike expected over the next 12 months, according to CME FedWatch, an outlook that could prove supportive for financial markets.

Key fundamental drivers for markets remain a source of strength

Although inflation remains a challenge for households and businesses alike, several underlying trends continue to help support a favorable economic and market backdrop:

• Healthy economic momentum. The U.S. Bureau of Labor Statistics estimated the real gross domestic product (GDP) in the U.S. increased by 2.1% in the first quarter of 2026 and 1.5% in the second. According to the Atlanta Fed GDPNow forecast, real GDP growth for the third quarter is trending closer to 4%. While growth may bring with it inflationary risks, solid economic momentum may also allow potential monetary policy adjustments to become easier to digest.
   
• Steady consumer spending. Consumer spending has recently been among the top contributors to economic growth, helping to boost momentum. Further highlighting the resilience of the consumer, U.S. retail sales have accelerated this year. While retail sales fell in July and consumer sentiment remained subdued, which may each take additional pressure off the Fed to hike rates in the near term, retail sales remain a strong 4.7% higher than levels from 12 months ago.
   
• Strong earnings across a range of sectors. 2026 earnings expectations for the S&P 500 have strengthened considerably over the course of the year, with full-year growth estimates now exceeding 30%. What's more, upward revisions have been broad-based, and particularly strong for technology, commodity-related, and economically sensitive sectors. Encouragingly, all sectors are expected to deliver positive earnings growth, underscoring the breadth of momentum.

Bottom line: While inflation and geopolitics may periodically dominate market attention, we expect these key fundamentals—healthy economic momentum, steady consumer spending, and broad earnings growth—to help underpin equity markets, creating a favorable backdrop and potential opportunities for disciplined investors.

For investors, emphasize diversification to capture a broad mix of opportunities

While inflation has moderated, the path back to the Fed's target may not be perfectly smooth. That uncertainty reinforces the value of maintaining a diversified portfolio over making concentrated bets on any one inflation scenario. We believe equities serve as a cornerstone for that strategy, offering long-term growth potential to help preserve purchasing power, providing a level of inflation protection over time, despite the potential for periodic market volatility along the way.

When working with your financial advisor, consider maintaining a strategic, well-diversified stock-bond mix aligned with your financial goals and risk tolerance, while incorporating an opportunistic lean toward stocks, given what we believe to be a constructive economic backdrop. We favor overweight allocations to a mix of equities, including U.S. large- and mid-cap stocks, emerging-market equity, and international value-style stocks. In our view, this combination helps capture timely opportunities tied to both AI-driven innovation and broader economic growth, while maintaining an emphasis on quality and diversification.

Tom Larm, CFA, CFP®
Portfolio Strategist

Sources for all data in commentary, unless otherwise noted: U.S. Bureau of Labor Statistics, FRED, FactSet

Previous weeks' weekly market wraps

8/7: Easing headwinds clear the way to new highs

7/31: Fed and tech earnings take center stage

7/24: Will the rise in oil prices force the Fed's hand?

7/17: Markets take a breather as earnings outlooks come to the forefront

7/10: Geopolitics Grabs Attention, but AI Sets the Direction

7/2: Three economic trends to monitor as we head into the second half of 2026

6/26: Fueling Opportunities with Lower Oil