The unexpected cooling of June inflation data has completely removed the possibility of a Federal Reserve interest rate hike in July. In a report released on July 19, Goldman Sachs Chief Economist Jan Hatzius noted that the improvement in inflation has essentially locked in a decision to hold rates steady at this month's FOMC meeting. However, the real challenge for Fed Chair Powell lies in effectively managing market expectations and preventing an overshoot in financial conditions during any policy shift.

According to the report, Goldman Sachs estimates that the June core PCE rose a modest 0.18% month-on-month, with the year-on-year rate increasing to 3.3%. The core CPI came in at just 2.6% year-on-year, while the trimmed-mean PCE was even lower at 2.3% year-on-year. Hatzius believes this data set has "effectively eliminated" any chance of a rate hike at the July 28-29 FOMC meeting. He warns that if policy needs to be adjusted in any direction, Powell will have no choice but to provide a more detailed explanation of the Committee's economic outlook and reaction function than he did in his initial press conferences and congressional testimonies. Failure to do so could make market narratives difficult to control.

Goldman Sachs' forecast for the Fed's policy path remains significantly below current market pricing. Its base case scenario (35% probability) involves one 25-basis-point rate cut each in June and December 2027, while the probability of a rate hike scenario is only 25%. The report also notes that Goldman Sachs interest rate strategists believe the market is currently overpricing tightening. However, as long as risks of escalating tensions in the Middle East continue to dominate market sentiment, this pricing discrepancy is unlikely to correct in the short term.

Inflation Cools, July Rate Hike Window Closes

Goldman Sachs estimates that the June core PCE rose 0.18% month-on-month to 3.3% year-on-year. Other inflation indicators were similarly mild: core CPI was just 2.6% year-on-year, and the trimmed-mean PCE rose 0.14% month-on-month to 2.3% year-on-year. Hatzius points out these data collectively confirm a substantial improvement in inflation, and the possibility of a July FOMC hike has been "effectively eliminated."

The report further states that core PCE in the US is a clear outlier at the high end among G10 economies. Core inflation in other G10 economies (whether measured by the traditional ex-food-and-energy metric or the trimmed-mean) has already fallen to around 2.1%, despite an energy price shock from March to April this year. Goldman Sachs believes the higher US core PCE is partly due to statistical measurement issues, including software and accessory prices not being quality-adjusted, portfolio management fees measured in dollar terms rather than basis points, and US-specific shocks like tariffs.

Looking ahead, Goldman Sachs expects that adjustments to the statistical methodology for software and accessory prices in September will reduce the year-on-year core PCE growth rate by approximately 0.2 percentage points. The firm forecasts that year-on-year core PCE inflation will gradually decline towards 2% by 2027, primarily driven by the fading contributions from software and accessories, the pass-through effects of energy prices, and the effects of tariffs.

Powell Must Detail Reaction Function to Prevent Financial Conditions Overshoot

Goldman Sachs believes that while improved inflation rules out a July hike, the possibility of rate increases at subsequent meetings remains, contingent on inflation being significantly higher than expected and the unemployment rate being markedly lower than anticipated. A deeper challenge is how the FOMC can effectively guide market expectations in the absence of a dot plot or when acting at non-routine meetings.

Hatzius explicitly stated that to control the market narrative and prevent financial conditions from tightening or loosening excessively, Powell will have "no choice" but to explain the Committee's economic outlook and policy reaction function to the market in greater detail than before. This requirement comes against a backdrop where Goldman Sachs interest rate strategists believe the market is already overpricing tightening. However, this pricing bias is expected to persist as long as the risk of escalating Middle East tensions remains unresolved.

According to Goldman Sachs' scenario distribution, the base path (35% probability) involves 25-basis-point rate cuts in June and December 2027. The probability of a rate hike scenario is 25%, while the probability of a high-inflation/high-growth/higher-terminal-rate scenario is also 25%. The probability of a recession scenario is 15%. The overall probability-weighted path remains below current market pricing.

Labor Market Cools, Consumption Faces Pressure in Second Half

Regarding the job market, the weaker-than-expected June non-farm payrolls report led Goldman Sachs to revise down its estimate of the underlying trend in job growth from 130,000 per month to 73,000 per month. Although the unemployment rate fell to 4.2%, Goldman Sachs attributes this decline primarily to an unusually large drop in the labor force participation rate, which is expected to rebound in the coming months and should not be overinterpreted.

Other labor market signals are also weak: household assessments of the job market remain subdued, with both job inflows and outflows constrained. Goldman Sachs' wage tracker has slowed to 3.4%, below the 4% level consistent with a 2% inflation target (assuming a 2% productivity trend).

On the consumption front, Goldman Sachs estimates the US economy expanded at a trend rate of about 2.25% in the first half of the year, with the effects of tax cuts offsetting the impact of high oil prices on consumers. However, the outlook for the second half is weakening. Slowing growth in real disposable cash flow is expected to weigh on consumer spending, and pressure will intensify if oil prices remain elevated. Furthermore, if the AI investment boom cools, the approximately 0.5 percentage point contribution to consumption growth from stock market wealth effects would face downside risks, adding another source of uncertainty.