Inflation and US monetary policy: the markets have made their choice…for now - 15 june 2026

After the 2025 tariff hikes and the 2026 Iran shock, the boom in AI-related spending is helping to push US inflation higher. Will this succession of shocks ultimately keep inflation durably above 2%, or will it calmly return to its bed in 2027? The debate is raging just days before the 17 June Fed monetary policy meeting, chaired for the first time by Kevin Warsh, who is widely seen as optimistic on this crucial issue.

Measured by the consumer price index, US inflation reached 4.2% in May, its highest level since the post-Covid period (Chart 1). The Federal Reserve’s preferred gauge – the personal consumption expenditures (PCE) deflator – will probably stand at 4%.

In May, employees’ purchasing power fell year-on-year for the second month in a row (-0.7%). Will wages therefore start to accelerate again, raising the risk of a price–wage spiral – as in 2022–2023 – that would force the Fed to engineer a sharp economic slowdown? In this respect, the precedent of the 2025 tariffs – whose inflationary effects persisted until spring 2026 – is reassuring (Chart 2). Unlike during the post-Covid boom of 2022–2023, the labour market was sluggish in 2025, which was less conducive to wage increases. Moreover, the impact of tariffs on annual inflation will gradually fade away by the beginning of 2027.

One could stop there, but the diagnosis is less straightforward than it seems. Energy, rents, software, electronic goods, food and tariffs will exert conflicting influences on the inflation rate over the coming months. Beyond these uncertainties, however, one crucial question is preoccupying the Federal Reserve: can an underlying trend be identified? Over recent decades, many methods have been proposed to answer this: measuring median inflation, stripping out the most cyclical components, excluding the highest and lowest components each month (trimmed mean), or modelling co-movements using a so called “multivariate” statistical approach.

Unfortunately, these measures currently produce highly divergent results (Chart 3). Kevin Warsh has repeatedly referred to the trimmed mean, which gives the most favourable reading, at 2.3% in April (and probably 2.4% in May, according to Goldman Sachs’ forecasts). Conversely, the multivariate model, which correctly signalled the upturn in inflation in 2021 and the subsequent disinflation in 2023, is considerably more worrying, at 4% in April. However, this latter measure is at time subject to significant revisions. On average, the various indicators suggest that underlying inflation has been hovering around 3% since mid 2024, and that the very recent trend may be edging slightly higher.

Most members will probably agree that underlying inflation remains above the 2% target, even once the temporary impact of tariffs is considered. Some – probably including Kevin Warsh – will argue that the deviation from 2% is small, and that the pressure exerted by current interest rate levels on sectors such as real estate will allow inflation to return to the 2% path once the impact of the Iran crisis has faded. This is the scenario envisaged by Goldman Sachs, which expects 2% to come into view from the second quarter of 2027. Others will be more sceptical and point out that the recent improvement in the labour market strengthens the case for postponing any rate cuts or even raising rates again if this trend persists.

In the face of this debate, the market has opted for maximum caution. Since the start of the Iran crisis, implied expectations in the money markets have shifted from two Fed rate cuts to one rate hike, and possibly a second at the start of next year (Chart 4).

This interest rate path is probably out of line with what Kevin Warsh has in mind, unless he has already shifted his position. Markets, for their part, are betting on the Federal Reserve’s traditional reaction function, with no major change despite Kevin Warsh’s arrival. They are factoring in both doubts about the underlying inflation path and the resilience of a US economy that, at this stage, does not appear to need rate cuts. In contrast with equity markets, which have often been described as complacent in recent weeks, bond markets therefore remain rather wary.

Yet the significance of US inflation data goes well beyond short term questions currently focused on the Strait of Hormuz. If underlying inflation were really to settle back neatly at 2% in 2027 despite the succession of shocks – Covid, tariffs, the Iran crisis, the boom in AI related spending – together with a gaping public deficit (7.5% of GDP) and near full employment, who would still believe in the return of inflation risk? Some policymakers – Kevin Warsh among them – seem even more willing to back this optimistic scenario because they are betting that AI will unleash a deflationary boom. But some economists – including Charles Goodhart – argue instead that inflation is likely to become entrenched, partly for demographic reasons(1). There is little doubt that the next eighteen months will go a long way towards resolving this crucial question for both the world economy and the valuation of financial assets.

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(1) The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival, de Charles Goodhart et Manoj Pradhan (2021)