The July Consumer Price Index (CPI) report indicated a notable acceleration in core inflation, marking the largest monthly gain in six months and pushing annual core prices to a five-month high. This data has significantly influenced market sentiment, increasing the probability of a Federal Reserve interest rate cut in September, even as persistent tariff-driven price pressures remain a concern.

July CPI Report: Core Inflation Rises by Most in Six Months

U.S. equities reacted positively to the latest Consumer Price Index (CPI) report for July, which, despite an acceleration in core inflation, solidified investor expectations for a Federal Reserve interest rate cut in September. The core CPI, excluding volatile food and energy prices, rose 0.3% month-over-month, marking its largest gain in six months. Annually, core prices increased to 3.1%, up from 2.9% in June and reaching their highest level since February.

The Event in Detail: Underlying Price Pressures Persist

The Bureau of Labor Statistics reported that the headline CPI advanced 0.2% over the month, with the annual inflation measure remaining stable at 2.7%. While energy prices declined and food costs remained unchanged, the persistent rise in core inflation points to underlying price pressures, particularly in services. The index for shelter costs increased by 0.2% in July, serving as the primary factor contributing to the overall monthly index. Core goods prices saw a 0.2% rise for the second consecutive month, with notable increases in categories such as household furnishings (up 0.7%) and window and floor coverings (a 1.2% rise).

Analysis of Market Reaction: Dovish Expectations Mount

Following the CPI release, the probability of a 25-basis-point interest rate cut by the Federal Reserve in September surged to 90.0%, up from 85.9% the previous day, according to the CME FedWatch tool. This heightened expectation of accommodative monetary policy spurred a positive reaction across equity markets. Nasdaq futures rose 0.7%, S&P futures increased 0.6%, and Dow futures gained 0.6%. Concurrently, the 10-year Treasury yield fell 2 basis points to 4.267%, reflecting increased investor confidence in potential rate easing. This market response signals a shift towards a "risk-on" sentiment, as investors anticipate improved liquidity and corporate borrowing conditions.

Broader Context and Implications: Tariffs and Economic Headwinds

While the market welcomed the increased likelihood of a rate cut, underlying concerns about persistent inflation, particularly driven by tariffs, remain. New U.S. tariffs that took effect on August 7 raised the average effective tariff rate to 17.6%, the highest level since the early 1930s. This has contributed to ongoing price increases in goods like footwear, furniture, and apparel. The U.S. footwear industry, for instance, faces some of the highest tariffs, with total duties exceeding 100% on some imports, notably from China. Industry bodies like the Footwear Distributors and Retailers of America (FDRA) warn that these tariffs will continue to elevate consumer prices, hurt sales, and strain the industry, with 82% of footwear executives expecting higher landed costs in 2025.

This complex inflation picture presents a challenge for the Federal Reserve as it attempts to balance controlling inflation with supporting economic growth. While the Gross Domestic Income (GDI) saw a solid 4.8% rise in Q2 2025 and corporate profits rebounded, broader economic signals are mixed. Consumer spending, which accounts for nearly two-thirds of U.S. GDP, has stagnated in 2025, marking its weakest stretch since the aftermath of the 2008 financial crisis. This stagnation is largely attributed to sluggish wage growth, persistent inflation, and economic uncertainty, leading households to curb spending. Job growth has also slowed to a "virtual standstill" in many sectors, raising concerns about a potential recession by the end of 2025.

Expert Commentary: A "Better-Than-Feared" Outcome

Economists weighed in on the implications of the CPI data. Tom Porcelli, Chief U.S. Economist at PGIM, described the outcome as "better-than-feared," noting the market's swift reaction to price in a September rate cut.

"This is one of these better-than-feared outcomes. People are probably going to use this as a sign that the Fed could cut rates in September. And I don't doubt for a second that that's exactly how the market is going to react," Porcelli stated.

He further commented on the nature of tariff-induced inflation, indicating it will be an ongoing process rather than a one-time event.

"The core message in core inflation is that any tariff-induced inflation is likely to be a process, not an event. Eventually, tariffs can show up in varying degrees in consumer prices, but these one-off price increases don't happen all at once. That will confound the Fed and economic commentators for months to come."

Looking Ahead: Fed's Balancing Act and Persistent Pressures

The path forward for the Federal Reserve involves a delicate balancing act. While market participants are increasingly confident in a September rate cut, the persistence of core inflation and the ongoing impact of tariffs suggest that inflation may remain above the Fed's target for some time. The Fed's ability to navigate these dynamics will be crucial in shaping the economic trajectory and market performance in the coming months. Investors will continue to monitor upcoming economic reports, particularly those related to inflation and the labor market, for further cues on the Fed's monetary policy decisions and the broader economic outlook.