With the odds of the Federal Reserve raising rates in September hanging in the balance at roughly 50/50, the July Consumer Price Index (CPI) report only needs to deviate slightly from expectations to tip the scales. The market's focus is not simply on whether inflation is falling, but on whether it can return to the 2% target without further rate hikes, with the key insight perhaps coming down to a single number.
The unexpectedly weak July jobs report is still not enough to make the Fed completely abandon the possibility of a near-term rate hike. However, if the July CPI (due for release on Wednesday) shows a second consecutive month of moderation, it could be the decisive blow to douse expectations for another hike. Consequently, the importance of the July CPI has significantly increased: if inflation continues to cool, the Fed may hold steady at least until October; if core inflation re-accelerates, expectations for a September hike could quickly heat up.
Surface-Level Cooling, Core Inflation is the Real Focus
Markets expect the US July CPI to rise just 0.1% month-over-month, remaining mild after its first decline in six years in June. The year-over-year increase is forecast to fall to 3.4% from June's 3.5%, extending the retreat from the three-year high of 4.2% in May. If looking only at headline CPI, the Fed appears to have little reason to rush into a rate hike. But the problem is that a sharp drop in gasoline prices in the first half of July likely artificially depressed the headline number, making the core CPI, which excludes food and energy prices, the real metric to watch.
Markets project that core CPI rose 0.2% month-over-month in July, with the annual rate easing to 2.5% from 2.6%. This suggests inflation is indeed slowly improving, but it remains clearly above the Fed's 2% target and would mark the sixth consecutive year it has been above that level. Bob Edwards, Chief Investment Officer at Edwards Asset Management, noted that a 2.5% inflation rate is "not that far" from the 2% target. While it's not a victory, it does represent progress. Of course, this improvement may not be enough to ease the concerns of the Fed's hawkish officials.
Services Inflation Remains the Biggest Concern
What Fed officials truly need to look for in the CPI report is whether inflation is becoming newly sticky. Prices for services like rent and transportation are particularly noteworthy. Service inflation has risen 3.2% over the past 12 months, up from 2.9% in early 2026, and has become a major reason why US inflation has struggled to return to around the 2% target. For example, UBS Global Research economist Jonathan Pingle expects the core inflation gauge to strengthen after a surprisingly soft reading in June, driven by a rebound in core non-rent services, where prices for transportation, healthcare, and communication services are expected to have returned to their normal pace of increase.
The current rise in inflation does not entirely signal a new round of broad-based inflation. Some price pressures this year have come from rising oil prices and the lingering effects of tariffs from the Trump administration. With the easing of the US-Iran conflict, energy prices still have room to fall in the future. The truly tricky issue is this: after stripping out these temporary factors, the underlying inflation in the US still appears to be stuck at 2.5% or even higher, with no clear signs of self-correction. This is a key reason why the Fed saw a rare split at its last meeting, with three officials voting for a rate hike and the final decision being a 9-3 vote to hold rates steady. Thierry Wizman, Global FX and Rates Strategist at Macquarie Group, pointed out that even a benign CPI report may not be enough to dispel the concerns of hawkish Fed officials about inflation remaining above target for years. Meanwhile, Fed Chair Kevin Warsh, while consistently emphasizing the need to push inflation back to target, has yet to substantiate his stance through concrete action.
September Rate Hike Decision Hangs in the Balance
Jeffry Bartash, a senior MarketWatch correspondent and economics analyst in Washington, believes the Wednesday CPI report could be the key data point determining expectations for the September rate decision. If core CPI rises by around 0.2% month-over-month, or even less than expected, and against the backdrop of July's first decline in nonfarm payrolls in six months, the Fed could gain a reason to stay on the sidelines, further cooling expectations for a September hike. However, if core CPI rises to 0.3%, especially reaching or exceeding 0.4%, market bets on a September rate hike could surge rapidly. Currently, Wall Street places the probability of a September rate hike at roughly 48%. This means that the July CPI does not need to show an extreme result to change the market's assessment of the September meeting. Bartash also noted that the Producer Price Index (PPI) due out this week is worth watching. While CPI and PPI may not directly determine whether the Fed will hike, the two data points together will form a crucial basis for the next policy decision.
For the Fed, the question is no longer simply "is inflation falling?" but rather, can inflation sustainably move towards 2% without further rate hikes? If the answer is no, a September hike could become a reality again. Conversely, if inflation remains moderate and the labor market shows signs of weakness, a premature rate hike by the Fed could further damage an already sluggish housing market and increase financing pressures for consumers and businesses. In short, the real focal point of this CPI report may come down to a single number: whether the monthly core CPI increase falls below the 0.2% threshold.
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