New Inflation Data Next Week—This Is a Big One

All eyes will be on Tuesday’s CPI data as the Fed ponders the inflationary impacts of the tariffs and whether it can resume rate cuts in the Fall as the market currently expects. So far, the effects appear to be limited. Goods price inflation remains muted through May, but the trade war is far from over. After a temporary truce to allow for negotiations, the President announced another round of tariffs on more than 20 countries with a new 50% tariff on copper by August 1. If implemented, we estimate that the average effective tariff rate in the United States would rise from the current 15% to around 18%, the highest since 1934—not the right direction to warrant the Fed to let down its guard on inflation.

Tariff pass-through may have been delayed for several reasons including uncertainty about tariff duration and final levels, stockpiled inventory, supply-chain adjustments, long-term contracts, and even competitive pressures due to price-sensitive demand. Until the Fed can better disentangle these effects and gauge how much of the shock has already been fully passed through, it will likely need to stay on the sidelines. And, of course, the new tariff shocks keep coming.

Encouragingly, the June FOMC Minutes noted that the Fed staff forecasts for GDP growth and inflation had improved since May and that recession risks had diminished. This correlates well with the equity market rebound and the improvement in market-based inflation expectations over the period. The New York Fed’s Consumer Expectations Survey for June seemed to concur with the 1-year ahead inflation expectations measures moving lower for a second straight month (Chart 1). But, consumers’ more specific commodity price expectations 1-year ahead (from the same survey) paint a more complicated inflation picture. Consumers’ price expectations for medical care, college education, rent, food, and gas continue to rise, and for the most part have already returned to earlier pandemic levels—a steep climb since the turn of the year (Chart 2).

That’s why June’s CPI report is so consequential. Investors have taken a glass half-full position on tariff inflation risks, betting that expectations will remain well-anchored and that the Fed will look through any pickup in goods inflation as services inflation cools. Fed funds futures are currently pricing in about a 70% chance of a September cut. However, the delayed pass-through of the tariffs and ongoing trade war raise the risk the Fed will have to wait longer than expected before the path forward on policy becomes clear. From March through May, big declines in gas prices and moderating services inflation helped to keep overall price pressures under wraps (Chart 3). But the June CPI data could be an important test of this favorable trend. Oil prices increased by 10% and retail gasoline prices were largely flat, suggesting less of a tailwind from diminishing energy inflation. At the same time, further improvement in services may be more difficult to come by, now that many categories have already cooled down. The June ISM Prices Indexes for manufacturers and services firms are telling as they continue to suggest elevated price pressures (Chart 4).

We expect an increase in June CPI and core inflation to 0.29% and 0.26%, respectively, from tame 0.08% and 0.13% increases in May. From a year ago, CPI inflation should heat up two-tenths of a percentage point to 2.6% with the core measure increasing a tenth to 2.9%. An upside surprise could lead to a big shift in Fed interest rate expectations and longer-term Treasury yields.

Tales from the Trade-War Trenches

If you think you’re up-to-date on the Administration’s tariff war, just wait a few minutes (to borrow from a Mark Twain quote). Below, we take stock of this week’s burst of trade policy announcements with the caveat that this note was published on Friday at 12:00, with many more minutes left in the week.

July 9 marked the end of the 90-day postponement of ‘reciprocal’ tariffs. According to the Wall Street Journal, Treasury Secretary Bessent convinced President Trump to push the deadline to August 1 to allow more time for trade deals to be struck, which the President announced on July 7. As the week unfolded, a flurry of letters was sent to individual countries informing them what tariff rate they would face for the privilege of trading with the United States come August 1. The proposed tariff rates look a lot like the April 2 ‘reciprocal’ tariff rates that were postponed, with a few exceptions that we discuss below.

So far, 23 letters have been sent out over social media, comprising around 29% of U.S. imports (Table 1). Many of the countries don’t have meaningful trading relationships with the U.S. (e.g., Moldova, Bosnia and Herzegovina, and Brunei to name a few) and so tariffs on them will have limited macroeconomic impact. But for an administration keen to demonstrate that it remains all-in on tariffs as a policy tool, it sends a message (are you listening Europe?). However, six of those countries make up the lion’s share of that 29% and if the U.S. goes ahead with those tariffs, the average American consumer will start to feel the pinch at the store.

Canada is the most notable letter recipient, which will now face 35% tariffs (up from 25%) starting on August 1. USMCA-compliant goods will remain exempt according to reports (the letter doesn’t directly make that distinction). The exemption for USMCA-compliant goods will continue to mitigate the effects of tariffs on both the Canadian and U.S. economies—as of May, the calculated tariff rate (customs duties as a share of imports) on Canadian exports to the U.S. fell to 1.9% in May (from 2.3% in April), which suggests better than 90% USMCA compliance (or limited enforcement of stated tariff rates by the U.S.). However, it doesn’t appear that the Canadian trade negotiators have made much progress on thawing the frosty trading relationship with the United States.

The inclusion of Brazil on the list, particularly with such a high threatened tariff rate (50%) is odd. Originally, the U.S. was concerned about trade deficits, but it runs a trade surplus with Brazil. Unlike most of the letters sent out, the language in the letter to Brazil was unique in that it seemed to argue that the tariffs were in retaliation for its treatment of former President Bolsonaro in domestic legal proceedings. Hence, tariffs are now being stretched as a policy tool to influence political dynamics in other countries.

There were also developments on the sector tariff front. President Trump announced a 50% levy on imported copper effective August 1. He posted about receiving a “robust” national security investigation, concluding that tariffs were necessary. The ‘Section 232’ (Trade Expansion Act of 1962) study was initiated March 10, with the Commerce Department’s report due within 270 days (9 months). The report hasn’t been published yet but Secretary Lutnick said tariffs could be in place by the end of July. The levies could potentially cover copper in all its forms: copper ore, copper concentrates, refined copper, copper alloys, scrap copper, and derivative products. America currently imports about half of its copper needs according to reports.

There is also a Section 232 investigation under way into pharmaceuticals and related ingredients (it was initiated April 1). This week, President Trump threatened to impose a 200% tariff “very soon”. But it wouldn’t be effective for a while, so companies have time to re-shore production and establish new plants.

And finally, from a geopolitical standpoint, President Trump also threatened members of the BRICS group and “any country aligning themselves with the Anti-American policies of BRICS” with an additional 10% tariff (on top of the others already put in place or announced).

The adversarial turn in U.S. trade policy once again doesn’t bode well for the outstanding negotiations with other countries that have yet to receive letters (Europe, China, Mexico), but perhaps it’s a rushed attempt to exact leverage before the President’s authority to impose tariffs is potentially curtailed by the courts. We hope that the trade negotiators of the world weren’t expecting a long summer vacation because it will be an intense three weeks leading into the new August 1 deadline for ‘reciprocal’ tariffs.

Big Beautiful Bump (to Growth)

After slowing partly due to the trade war, the U.S. economy will get a lift from the new budget bill.

On Independence Day, Congress passed the sweeping One Big Beautiful Bill Act (OBBBA), meeting a self-imposed deadline. The centerpiece of the Act are tax cuts and more spending on defense and border control, partly offset by reduced funding for health care, food stamps, and student loans. Analysts expect the Act to raise the budget deficit and lift the economy in the near term. But by how much?

Taxes cut

The OBBBA’s marquee revenue measures include the permanent extensions of the tax cuts from 2017’s Tax Cuts and Jobs Act (TCJA) that were slated to expire January 1, 2026. For example, most of the seven personal income tax rates were poised to rise between 3 and 4 percentage points (ppts). In addition to being extended permanently, some TCJA measures were also enhanced. For example, the child tax credit, scheduled to drop to $1,000 next year from $2,000 currently, was lifted to $2,200 and will now be adjusted for inflation. Also, instead of being extended at $10,000, the SALT (state and local tax) deduction was temporarily lifted to $40,000. And other TCJA measures that were already being phased out were revived, such as bonus depreciation. The TCJA’s original 100% rate began dropping by 20-ppt annual increments in 2023 (to 40% for 2025). This is now set permanently at 100% beginning this year. The enhancement and revival of TCJA measures added to the price tag of the extension. The Committee for a Responsible Federal Budget (CRFB) pegs the TCJA-related total impact at $4.6 trillion, compared to the Congressional Budget Office (CBO) baseline. (Going forward, all dollar figures refer to 10-year totals over the budget period ending 2034.)

The OBBA’s other major revenue measures (see Table 1 at the end) reflect some of the tax cuts promised during the election campaign. For example, no taxes on overtime pay or tips (both with limitations), along with a new tax deduction for auto loan interest and an increase in the standard deduction for seniors. (The latter is in lieu of more costly tax-free Social Security benefits that were promised.) Elsewhere, bonus depreciation was expanded to new factories. Note that all the new measures mentioned above sunset after 2028, partly to keep their total deficit cost down. Still, they amount to around $700 billion (CRFB), resulting in $5.3 trillion worth of total (gross) tax reductions. Interestingly, the OBBBA’s revenue offsets add up to just over $700 billion (CRFB), led by the repeal and reform of Inflation Reduction Act (IRA) tax credits (worth almost $545 billion). All in, the CBO estimates total revenue will fall by $4.5 trillion compared to the budget baseline.

Spending sliced, but by less

The OBBBA cuts total spending by $1.2 trillion compared to the CBO’s baseline. The largest slices to outlays occurred in three buckets. The first was health care, with a $1.1 trillion hit (CRFB). The bulk of this was reduced funding for Medicaid via establishing work requirements and tightening eligibility/enrollment rules, along with ‘savings’ in administering the Affordable Care Act. The CBO estimates that millions of Americans could lose health insurance coverage as a result.

The second bucket was student loans, with a reduction of more than $305 billion (CBO). This mirrors stricter loan repayment and Pell Grant eligibility rules, along with lower borrowing limits and thus lower loan volumes over time. Note that under federal budget accounting rules, the ‘subsidy costs’ of student loans over their lifetime are measured on an accrual basis and recorded in the first year of the budget. As such, $172 billion in ‘subsidy savings’ on student loans are recorded in FY2025, amplifying the improvement in the budget but with little real economic impact.

The third bucket was the Supplemental Nutrition Assistance Program (SNAP, a.k.a. ‘food stamps’), with an impact of around $185 billion (CRFB). This includes more stringent work requirements and eligibility rules, along with passing more of the program’s costs to the states. The CBO estimates that several million people could lose access over the budget period.

Spending on defense and border security saw the biggest boosts, with their (committee) outlay envelopes expanding by $150 billion and nearly $130 billion, respectively (CBO). The latter includes $45 billion for expanding Immigration and Customs Enforcement (ICE) detention capacity to facilitate mass deportations. This could have significant negative impacts on industries that (knowingly or unknowingly) employ undocumented workers such as agriculture, construction, and hospitality.

Current law vs. current policy

Given the $4.5 trillion decrease in net revenue and $1.2 trillion drop in net spending, the OBBBA increases the cumulative deficit by $3.3 trillion, compared to the CBO’s baseline (ignoring additional interest payments, which could amount to nearly $715 billion according to the CRFB). The CBO baseline projection is the standard for measuring fiscal impacts of policy changes, and it assumes that policy evolves as existing laws dictate (a.k.a. the ‘current law’ baseline). The CBO’s latest (January) forecast assumed the expiring 2017 tax cuts would, in fact, expire (Chart 1). As a result, the baseline deficit projection shows an improvement as relatively more taxes roll in starting in calendar 2026, despite the economy falling over a fiscal cliff on January 1. The hit to disposable income from higher tax rates alone would be enough to push real GDP growth into negative territory in early 2026. This is one reason that at least some of the tax cuts would have been extended regardless of the outcome of last year’s elections.

The CBO can also produce another budget projection based on existing policies remaining in place regardless of what current laws dictate (a.k.a. the ‘current policy’ baseline). This provides a better jump-off point for assessing economic impacts, given that existing tax policies are remaining in place—and then some. Apart from a potential positive impact on sentiment and investment, the extension of the 2017 tax cuts likely won’t have a material effect on the economy. In Chart 2, we show how the OBBBA’s policy changes, beyond extending the TCJA tax cuts, impact the budget balance. Revenues are down almost $830 billion with most of the impact occurring before the new temporary tax cuts end in calendar 2029. Spending is down a net $1.3 trillion, resulting in nearly $510 billion in net deficit reduction. The latter should be a net negative for economic growth over the next decade, although the tax cuts (beyond extensions) should provide some near-term lift.

The CBO’s ‘current policy’ baseline sees the OBBBA reducing the budget deficit by $47 billion in FY2025, which normally would ding the economy. But the up-front recording of $172 billion in student loan ‘subsidy savings’ explains the entire improvement in the deficit, which, as mentioned earlier, greatly overstates the negative impact on the economy. Excluding this accounting effect, the OBBBA would actually increase the deficit by $125 billion in FY2025, or 0.4% of GDP. Some of the economic lift will come from a reduction in employer withholding rates on overtime pay and tips.

Alas, other policies will likely more than offset OBBBA’s economic push in 2025. DOGE-related cuts to the federal government could ramp up after a recent Supreme Court decision repealed a lower court’s ruling that blocked large-scale layoffs. Deportations are now showing up in the workforce data and could accelerate due to increased funding for immigration enforcement. A recent Dallas Fed study found that real GDP growth could be 0.8 ppt lower in 2025 if current deportation trends (about 88,000 annually) persist and 0.5 ppt lower in 2027, with the latter rising to 1.5 ppts if deportations reach one million annually.

The trade war will also weigh on growth. Based on work by the Fed, and assuming limited retaliation, a 15% average effective tariff rate on U.S. imports could reduce annual GDP growth by about one-half percentage point. This week’s round of ‘tariff letters’ suggests we could land on a figure 3 ppts higher on August 1. Any new tariffs will help to plug a revenue hole and lower the budget deficit, but will also depress growth. In May, customs duties totaled an annualized $266 billion (Chart 3). However, this figure was flattered by 145% tariffs on Chinese goods, which were lowered to 30% for the second half of the month. Nevertheless, if we assume a 10% average tariff on America’s $3.3 trillion worth of annual imports, this could generate $330 billion per annum, other things equal. However, it’s unclear what portion of the tariffs will be absorbed by foreign exporters and, thus, how much U.S. import prices (and the prices of import-competing goods) will rise. It is also unclear how an erosion of purchasing power will impact tax revenues, though we are assuming some hit.

All in, the DOGE cuts, deportations, and tariffs tend to support our call for real GDP growth slowing to 1.0% (on a fourth quarter-over-fourth quarter basis) in 2025 from 2.5% in 2024.

Some rolling back of tariffs and more clarity on trade policies are assumed over time, reducing uncertainty and allowing the growth drag to fade in 2026—just when OBBBA’s push will more fully kick in. The CBO’s ‘current policy’ baseline estimates the Act will increase the deficit by $270 billion in FY2026. That, relative to the earlier mentioned $125 billion increase in FY2025 (sans the student loan subsidy savings), amounts to a 0.5 ppt lift to GDP growth in 2026. Some additional indirect support could stem from the accelerated deduction allowances for businesses raising the capital stock, and from lower taxes on overtime pay increasing work incentive. This, together with an assumed fading effect of the trade war and resumption of Fed rate cuts, aligns with our view of GDP growth improving to 1.7% in 2026.

Bottom Line: While the economic effects of the OBBBA are uncertain, the heavily front-loaded tax cuts and spending hikes for national security look to more than offset cutbacks, pointing to a potential one-half percentage point lift to growth in 2026. Effectively, the tax cuts for individuals and businesses will paper over higher import taxes. This could reinforce the Fed’s current go-slow approach to easing for now, but may not be material enough to fan inflation, especially given some supply-side response of tax cuts, keeping policymakers on track to gradually restore policy neutrality from the current modestly restrictive stance.