Expectations for interest rate cuts cool down, and the probability of a rate hike in September rises to over 50%.

Written by: Bu Shuqing, Wall Street Journal

Goldman Sachs warns that the risk of inflation spread in the U.S. is now higher than the historical average, but far from the crisis level seen in 2022. Currently, price increases are mainly concentrated in a few high-weight sectors, with housing inflation expected to continue cooling down. The market has started to bet on a rate hike from the Federal Reserve in September, making the trend of inflation the biggest variable in the second half of the year.

The risk of inflation spread in the U.S. is becoming a reality, but the level is far from crisis.

Jessica Rindels, an economist at Goldman Sachs, shows in her latest research that based on the Fed's preferred inflation indicator, the Personal Consumption Expenditures (PCE), the current breadth of inflation is higher than the historical average from 1990 to 2019, especially performing prominently under a weighted basis. This conclusion resonates with the concerns expressed by the new Fed Chair, Waller, during his congressional hearing last week—Waller explicitly cited preventing individual price increases from "fully spreading" as one of his top responsibilities.

However, Rindels' research also provides an important reference point: on a customized quantitative scale from 0 to 10 (0 corresponding to the 1990 to 2019 average, and 10 corresponding to the inflation peak in 2022), the current breadth of inflation under the weighted basis reads 6, while the unweighted basis is only 2, both far below the extreme levels during the pandemic. The market's reaction has been relatively calm, with S&P 500 futures rising about 22 basis points before the market opened on Monday.

Quantitative Framework: How to Measure the Degree of Inflation Spread

Rindels employs a three-tier filtering method to establish the analytical framework:

Using PCE as the data source, the six-month annualized rate of change smooths short-term fluctuations, and statistics are calculated under two bases: weighted by the contribution of each category in PCE and unweighted by category.

Within this framework, the breadth of inflation is defined as the proportion of categories within PCE that have increased by more than 3%. A weighted basis reading of 6 means that the degree of inflation spread, calculated by consumption weights, has approached 60% of the peak level in 2022; meanwhile, an unweighted basis reading of only 2 indicates that price increases remain relatively concentrated in number of categories and have not spread broadly.

The significant difference between the two measurements indicates that current inflation pressures are primarily concentrated in larger-weight consumption categories rather than evenly distributed across various segments.

Price Increases Concentrated in Audio-Visual, Financial, Medical, and Transportation

Rindels' research points out that the areas with the fastest price increases currently are concentrated in four major categories: video/audio services, financial services, medical services, and airfares/transportation.

These categories are relatively high in PCE weight, which is the main source driving the higher reading in the weighted basis.

In contrast, while housing rents remain an important component of inflation, Rindels predicts that its impact will gradually wane—housing rent increases are expected to fall below 3% in the fourth quarter of this year, and the pull on overall inflation breadth will significantly weaken by then. This forecast provides the market with some easing signals for the outlook.

Market Pricing: Expectations for Rate Cuts Cool Down, Probability of Rate Hike in September Rises to Over 50%

Waller's congressional hearing last week was widely interpreted by the market as a hawkish tone.

Subsequently, the yield on 2-year U.S. Treasuries slightly retreated from nearly 4.3% to 4.18% on Monday, showing that the market adjusted after digesting his remarks.

According to CME FedWatch data, traders now estimate an 85% probability that rates will remain unchanged at the July meeting, but the probability of a 25-basis-point hike in September has risen to 52%. This indicates that the market has incorporated an additional rate hike into the baseline scenario, as the persistence of inflation spreads is reshaping expectations for Fed policy paths.

For investors, the core contradiction of the current situation lies in: although the breadth of inflation has exceeded historical norms, it has not yet triggered systemic risk; expectations for policy tightening are heating up, but the pace remains uncertain. Whether housing rents can cool as predicted will be a key variable in observing inflation trends in the second half of the year.