The July FOMC will most likely stay on hold, patiently waiting for inflation to continue easing

Overview

This U.S. economic weekly focuses on the July FOMC meeting, U.S. inflation and employment data, the transition in the tariff regime, changes in oil prices and financial conditions, and 2Q GDP tracking. The core conclusion is that recent employment and inflation data have given the Fed room to continue waiting, with the July meeting most likely to keep the federal funds target range unchanged at 3.50-3.75%, and to remain unchanged through the rest of the year.

Core views

The report argues that the Fed’s baseline choice is “patience” rather than resuming rate hikes. Concerns about labor market overheating have eased, payroll growth is close to the roughly 50k/month breakeven pace for employment growth, and the unemployment rate is broadly stable. On inflation, softer CPI, the winding down of tariff pass-through, and weaker housing inflation imply there is still room for further disinflation. At the same time, the report emphasizes upside risks to rates: if oil prices remain elevated, financial conditions continue to tighten, AI-related capital spending lifts the neutral rate, or the Fed’s reaction function turns more hawkish, the risk of rate hikes cannot be ruled out.

Analysis framework

The report combines macro data tracking with scenario analysis, focusing on employment, CPI/PCE, tariff revenue and refunds, oil prices and inventories, financial conditions indexes, GDP nowcasts, and the upcoming week’s data calendar, and maps this information to the Fed’s policy path and the U.S. growth outlook.

Methodology notes

• Monetary policy analysisFOMC reaction function assessment

  Assess whether the Fed needs to continue maintaining restrictive policy or hike rates further based on employment, inflation, and financial conditions.

  The report views softer employment and inflation data as evidence supporting a hold, while listing oil prices, AI capital spending, and changes in the Chair’s reaction function as higher-rate risks.

• Financial conditions analysisFRB/US Financial Conditions Index

  Use the 10-year Treasury yield, S&P 500 returns, BBB credit spreads, the dollar, and oil prices to measure the effect of asset prices on future economic activity.

  The index is interpreted as how many basis points of change in the federal funds rate would be needed to generate a similar economic impact; the report says financial conditions have tightened by the equivalent of about 67bp since the Middle East conflict began.

• Trade policy analysisEffective tariff rate tracking

  Assess the actual U.S. tariff burden by combining tariff authorizations, actual collections, refunds, exemptions, bilateral agreements, and import structure.

  The report argues that the expiration of Section 122 is not a tariff cliff, but a handoff to the Section 301 and 232 framework, with the statutory effective tariff rate around 9-10% by year-end.

• Growth trackingGDP tracking/nowcast

  Continuously update estimates of quarterly real GDP growth using high-frequency and monthly data.

  The report maintains 2Q real GDP tracking at 1.7% and compares the differences between the Atlanta Fed and NY Fed nowcasts.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• U.S. federal funds rate

  Core policy variable

  Strengths

  Softer employment and inflation support keeping 3.50-3.75% unchanged in July and through the rest of the year.

  Weaknesses

  If oil prices and second-round core inflation effects strengthen, or if the Fed’s reaction function turns more hawkish, the risk of further hikes remains.

  Comparison

  Compared with resuming hikes, the report’s baseline is more biased toward extending the pause.

  Risks

  Persistently high oil prices, AI investment lifting the neutral rate, and changes in the Chair’s reaction function.

• 10-year U.S. Treasury yield

  An important driver of tighter financial conditions

  Strengths

  Higher yields reflect resilient growth and changes in the risk premium.

  Weaknesses

  Rising yields effectively tighten monetary conditions and weigh on future economic activity.

  Comparison

  The report says financial conditions have tightened by nearly 50bp since the June FOMC, mainly due to the 10-year Treasury and the dollar.

  Risks

  Middle East conflict, oil price shocks, and rising inflation expectations could continue to push yields higher.

• U.S. dollar

  A component of the financial conditions index

  Strengths

  Dollar appreciation helps restrain some imported inflation.

  Weaknesses

  Dollar strength is also a source of tighter financial conditions and may affect growth and multinational earnings.

  Comparison

  Dollar weakness earlier in the year had loosened conditions, and the reversal since February 28 has tightened financial conditions.

  Risks

  Safe-haven demand, rate differentials, and geopolitics may amplify dollar volatility.

• Crude oil

  A source of inflation and financial conditions risk

  Strengths

  If the oil price shock fades, the disinflation path becomes clearer.

  Weaknesses

  After renewed escalation in the Middle East conflict, spot and futures oil prices have risen materially, reigniting inflation concerns.

  Comparison

  After the MOU it once neared pre-conflict levels, but it has risen again following the recent re-escalation.

  Risks

  Oil risk premium, lower SPR levels, and changes in inventories and exports could create second-round inflation effects.

• U.S. equities and credit spreads

  Offsets within financial conditions

  Strengths

  Strong equity markets and credit spread performance have offset part of the overall tightening.

  Weaknesses

  If risk sentiment reverses, financial conditions could tighten further and rapidly.

  Comparison

  Relative to Treasury yields and the dollar, equities and credit have contributed more as buffers to financial conditions.

  Risks

  Oil price shocks, growth downgrades, or policy surprises could trigger a pullback in risk assets.

• AI-related capital spending and imported capital goods

  Growth support alongside policy risk

  Strengths

  AI-related investment supports equipment investment and nonresidential fixed investment.

  Weaknesses

  Large imports of AI-related goods may widen the trade drag, while strong capital spending may raise the neutral rate.

  Comparison

  The Atlanta Fed shows stronger equipment investment but a larger drag from imports, and Morgan Stanley is waiting for trade data to validate the composition differences.

  Risks

  If AI investment reduces the restrictiveness of monetary policy, it may become harder for the Fed to pivot to easing.

Key data

• Expected July federal funds target range3.50-3.75%Morgan Stanley expects the July FOMC to remain unchanged and stay on hold through the rest of the year.
• June nonfarm payroll increase57kHiring slowed and prior data were revised down, with the long-run average close to the roughly 50k/month breakeven pace for employment growth.
• Unemployment rate4.2%The report says the unemployment rate changed little and concerns about labor market overheating have eased.
• Average hourly earnings y/y3.5% y/ySlower wage growth supports the view that labor market risks have become more balanced.
• Potential disinflation remaining60-70bpIf firms have completed tariff cost pass-through, the report estimates there may still be 60-70bp of disinflation in the pipeline.
• Year-end statutory effective tariff rate baselineapproximately 9-10%After Section 122 expires, the report expects the tariff framework to shift toward a combination of Sections 301 and 232.
• Average tariff rate for Mar-May 20266.8%The report estimates the average U.S. import tariff rate in March, April, and May 2026 was 6.8%.
• Effective tariff rate in May 2026approximately 6.9%Estimated based on May 2026 trade data.
• Financial conditions tightening since the Middle East conflictapproximately 67bpConverted into an equivalent change in the federal funds rate using the FRB/US model.
• Financial conditions tightening since the June FOMCnearly 50bpMainly driven by higher 10-year Treasury yields and dollar appreciation, of which about 30bp occurred in the past week.
• 2Q real GDP tracking1.7%Morgan Stanley is aligned with the Atlanta Fed’s aggregate tracking, while the NY Fed measure rose to 2.8%.
• 2Q consumption forecast2.4%The report expects 2Q consumption to remain resilient.
• 2Q nonresidential private fixed investment forecast5.0%AI-related investment and capital goods imports affect the composition of equipment investment and the drag from trade.

Impact & implications

For asset allocation, the report’s baseline scenario supports a near-term Fed pause, with limited upside for yields, but this does not imply rapid rate cuts. Higher oil prices, a stronger dollar, and rising 10-year Treasury yields will continue to tighten financial conditions. The tariff regime is more durable but with greater uncertainty in the details, potentially affecting import prices, corporate costs, and supply chains. AI-related capital spending supports investment and growth on the one hand, but on the other may raise the neutral rate and increase policy uncertainty.

Risks

• Oil prices remain elevated and push up core inflation through second-round effects.
• The Fed judges that the distribution of dual-mandate risks requires a tighter policy stance.
• AI-related capital spending raises the neutral rate, making current policy less restrictive than expected.
• The Fed Chair or Committee reaction function is more hawkish than assumed in the report.
• There is uncertainty around the scope, timing, exemptions, and refund arrangements of tariff tools such as Sections 301, 232, and 338.
• Escalation in the Middle East conflict continues to push up oil prices, the dollar, and Treasury yields, causing further tightening in financial conditions.
• Capital goods imports and AI-related goods imports may change the trade drag in GDP and the composition of equipment investment.

What to watch

• Whether the July FOMC statement and press conference maintain the language of “patience.”
• Whether subsequent CPI and core PCE continue to show disinflation, especially in core goods, housing, and services inflation.
• Oil prices, SPR inventories, U.S. crude production, exports, and net import data.
• The final scope, tariff rates, exemptions, and implementation timing of Section 301, Section 232, and Section 338 tariffs.
• The combined impact of 10-year Treasury yields, the dollar, credit spreads, and the S&P 500 on financial conditions.
• Revisions to 2Q GDP composition from June trade data and capital goods imports.
• Durable goods orders, the goods trade balance, house prices, PCE, personal income and spending, ECI, and University of Michigan inflation expectations.