# Goldman Sachs: The Interweaving of Cooling Inflation and Rising Geopolitical Tensions—FOMC July Preview

Since the Federal Open Market Committee (FOMC) meeting last June, inflation data has improved, but geopolitical news has worsened. We expect that the June core consumer price index (CPI) -2 basis points will translate into 18 basis points for the core personal consumption expenditures (PCE) price index, and will mark the start of a trend of slowing core inflation. We also expect that the recent methodological reforms announced by the Bureau of Economic Analysis (BEA) (partly aimed at correcting mismeasurement of the impact of AI) will reduce year-over-year inflation by 0.2 percentage points in the August report released in late September.

However, the renewed escalation of the Iran war and attacks on Russian refineries have pushed up energy prices, reigniting concerns that the already long run of supply shock may persist. The White House also announced new tariffs on Friday, even though these tariffs have little effect on the average tariff rate.

We expect the Federal Open Market Committee (FOMC) to keep the federal funds rate unchanged at next week’s July meeting. Chair Logan has previously said he supports a “modest increase” in rates, and may vote against holding steady and instead in favor of a hike; additionally, one or two other members may do the same. The meeting statement may acknowledge the upside inflation risks brought by the re-ignition of geopolitical conflicts, in order to signal that if conditions deteriorate, the Federal Open Market Committee could raise rates. We do not think Waller will reveal many clues about the policy outlook in his press conference, though he may also acknowledge that the recent rise in oil prices poses an upside risk to inflation. He recently named the five leaders to advance the monetary policy chair work group and may provide an update on their timelines.

Market pricing shows investors believe the outcome of the July meeting is unusually uncertain. If current pricing implying the probability of a rate hike is around 40% carries through until the meeting, then regardless of which outcome occurs, it will be the biggest surprise in decades compared with FOMC meetings that either raise or hold rates steady, because the Federal Reserve has historically avoided surprising rate hikes at meetings. The uncertainty may reflect that Chair Waller’s approach is starkly different enough to make people question whether historical patterns still apply; his own stance on a rate hike remains unclear; there has been disagreement within the FOMC recently; some of the renewed escalations with Iran occurred during a blackout period; and there could be further escalations before Wednesday.

Although we agree that uncertainty is higher than usual, it still appears that most voters are unlikely to push for a rate hike next week after the June inflation data came in soft, and some may be especially reluctant to deliver an unexpected rate hike at a meeting without an economic projections summary, fearing that the market could infer information beyond their intentions. Despite the rebound in oil prices, we still expect the combined impact of tariffs, the war, and AI measurement error on monthly inflation to fade over the coming months. Even so, there remains uncertainty about the war’s impact and the effect of the software and accessories category on monthly inflation. FOMC participants seem to fully accept the impact of AI demand on inflation data—contrasting with our view (and also the view of some Fed staff economists and the BEA)—and the FOMC’s June meeting minutes show that any sources of further strengthening inflation, including these three factors that a central bank might typically overlook, could be viewed as reasons for a rate hike. Our core PCE inflation forecast for the remainder of this year—starting from 18 basis points in June, 21 basis points in July, and 23 basis points in August—should be mild enough to keep the FOMC on hold through year-end. But comments from FOMC participants indicate that if inflation turns out worse than we expect, many may support a rate hike. Therefore, as we pointed out when the Iran conflict escalated again two weeks ago, we have little room to be wrong on inflation issues—and we suspect that a continuing conflict may affect the rate-hike debate more than the transmission effect of oil prices alone, because it amplifies concerns that supply shocks may persist and could unpredictably return even after they appear to have ended.

We noted last week that evidence from economic research suggests that a modest rate hike provides little countervailing anti-inflation offset to the larger inflation impact caused by supply shocks. We doubt Fed officials would agree, but if inflation news fails to improve as we expect, some may still believe it is important for the Fed to respond in order to avoid the public potentially misinterpreting its acceptance of high inflation. Many FOMC participants have also expressed concerns that sustained high inflation could ultimately “spill over” or “de-anchor” inflation expectations.

While we believe neither has happened in a dangerous way yet, some participants may think real-time judgment is difficult and would rather act early. For these reasons, although our baseline calls for the Fed to remain on hold through year-end, we have raised the probability of a rate hike from 25% to 35%. Even after the upward revision, our probability-weighted federal funds rate forecast remains more dovish than market pricing.