US inflation surprised in both directions last week, with headline surprising to the downside while core inflation surprised to the upside.
The markets initially took their cue from a lack of evidence of tariff-related pressures, with core goods inflation stable at a benign 20 basis points for the month of July. Market pricing for a September cut firmed, while the US equity market jumped.
It was interesting that the upside surprise in core inflation came from a lift in the services component (the part of the CPI not impacted by tariffs), with areas such as airfares and medical costs rising sharply. At the same time, a downside surprise in headline inflation was helped by a further fall in energy costs (gasoline prices).
We believe the Fed will succumb to the enormous political pressure being applied by the Trump administration and cut rates in September, despite core inflation picking up to a perky 3.1%. The Fed has one more CPI print before its September 17 decision, as well as another labour market report on September 5. The surprisingly weak recent labour market print has been a key driver of the large increase in expectations for a September cut (figure 5). Consequently, it has potential to shift expectations if it rebounds, or conversely, weakens further.
Is the Coast Clear on US Tariff Inflation?
In short, we don’t think so. We still expect tariff impacts on US inflation to increase, although the timing of the tariff effects on the CPI is quite uncertain. It could be late this year when the largest tariff impacts become clear. Additional tariffs have just been implemented in the past couple of weeks and further tariffs may come on board in coming months. An accumulation of inventory ahead of most of the tariff hit is also likely dampening the CPI, but inflation is likely to lift once this pre-tariff goods inventory is exhausted.
In addition, late last week the release of the Producer Price Index (PPI) disturbed the market's comfort on tariffs and inflation by surprising significantly to the upside. The sharp lift in the July PPI suggests that there are price increases taking place at the wholesale level that are likely to find their way into the CPI in coming months. The market pulled back the pace of near term easing, although pricing for a 25-basis point September cut is still well north of 90%. Equities sold off initially before stabilising.
We continue to expect that inflation rates will rise over the course of the year, with the main inflation aggregates rising to at least 3½% by the end of this year, if the current set of tariffs remains in place. As a result, we still see a scenario of uncomfortably high inflation but weak growth as a key narrative for the second half of the year. For now, the market is “glass-half-full” on the prospect of only moderate tariff inflation and the prospects of multiple Fed cuts, but this very benign scenario appears a little complacent in our view. We continue to watch the data closely over the next few months and retain some near-term caution on global equities.
RBA Cuts but Weighs in on (Lack of) Productivity Debate
Closer to home, the RBA cut rates as expected last week. The RBA did little to try to talk the market back from its view of at least two more cuts by early next year. However, in line with our view, the market has shifted more toward a November cut this year, rather than September, helped by a rebound in July employment last week.
The RBA’s focus in its policy statement was more on the lack of productivity growth in the Australian economy in recent years. Indeed, the RBA reduced its expectation of medium-term productivity growth from 1% p.a. to 0.7% p.a., leaving the RBA at odds with the government’s own assumption of 1.2%. This contributed to the RBA downgrade of GDP growth across 2026 and 2027 to only 2% from 2.3%.
Consequently, while inflation looks to be under control, growth is tepid, and the potential recovery is likely to be very muted in the eyes of the RBA. Medium-to-long-term growth potential looks constrained in the absence of either a positive productivity shock from AI, or productivity enhancing structural reform.
Last week’s policy easing and the prospect of at least two more rate cuts should help the economy pick up some momentum over the coming year and increase the relative attraction of both risk assets and fixed interest. However, the local market needs a more vibrant economy to improve its structural prospects, particularly with relatively rich valuations. We remain neutral Australian equities.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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