Peak inflation?

Bottom Line  

Sparked by powerful mid-year rallies of 21% and 31%, respectively, during the first half of this year, the S&P 500 and the Nasdaq Composite both orchestrated their best quarters in Q2 of this year since 2020, with stock prices hitting record highs in early June. What drove stocks into the stratosphere? Strong revenue and earnings growth, which surged by nearly 12% and 29% year-over-year (y/y) in the first quarter of 2026, with record net profit margins of 14.8%. The second quarter reporting season has just begun, and results could be even better when the dust settles. 

Follow the fundies This strong revenue and profit growth has followed solid economic fundamentals. The labor market, consumer spending, auto sales and manufacturing have all been constructive so far this year. Witness Citibank’s Economic Surprise Index, which soared from a three-month low of 5 in April to a three-year high of 63 in June. Business and consumer confidence troughed in May and is starting to improve. 

Solid labor market Nonfarm payrolls have risen by an average of 137,000 jobs over the past four months through June, compared with less than 10,000 jobs per month during 2025, and the rate of unemployment fell to a one-year low of 4.2%. 

Consumer spending strong While “Marpril” retail sales rose by a solid 4.5% y/y during the Easter/Passover season, consumer spending during May and June accelerated at a powerful 7.0% y/y pace. To be sure, enthusiasm surrounding the World Cup soccer tournament, our America250 celebration, and an earlier Amazon Prime Week may have accounted for some of this stronger consumer spending. With a strong June start in hand, we’re expecting a solid Back-to-School season overall.

Manufacturing solid The ISM manufacturing index has now been in expansion territory above 52 in each of the past six months through June for the first time in four years. All six of the regional Fed indices that we monitor have accelerated in recent months, and the Empire and Philly Fed indices surprisingly surged to much stronger-than-expected readings in July.

Inflation declines The big surprise for Wall Street was wholesale and retail inflation in June, which cooled noticeably from the spike we’d seen during March through May due to the ongoing conflict with Iran and the resultant spike in energy prices. However, some investors and central bank officials remain unconvinced that this positive inflection point in inflation is sustainable, which is likely a function of the uncertainty surrounding the war with Iran, who has been an untrustworthy negotiating partner with the US thus far.  

Energy prices driving the bus Inflation generally declined from a 40-year high in mid-2022 to a five-year low in January and February 2026, so trends were certainly moving in the right direction. But then came the start of the US/Israeli invasion of Iran on February 28. Oil prices (WTI) spiked by more than 84% to nearly $120 per barrel by March 9, and lagging gas prices rose by 53% since the end of February to a peak of $4.56 per gallon on May 20.   

Impact on inflation That drove nominal CPI retail inflation up sharply from a five-year low of 2.4% y/y in February 2026 to a three-year high of 4.2% in May, for a massive change of 1.8 percentage points. But that three-month surge was all due to the Iran-related spike in energy prices. How do we know that? Over this same period, core CPI inflation (which strips out volatile food and energy prices) rose from a five-year low of 2.5% in February 2026 to a seven-month high of only 2.9% in May 2026, for a modest 0.4 percentage-point change.

Fragile cease fire with Iran From its March 9 peak at nearly $120 per 42-gallon barrel, WTI plunged by 44% to $67 per barrel on July 2. Gas prices at the pump declined by 17% from $4.56 per gallon to $3.79 on July 6. As a result, we expected a sharp improvement in inflation during June. 

June inflation cools Nominal CPI inflation declined by a larger-than-expected 0.4% m/m in June 2026 (consensus 0.1% decline) versus a 0.5% m/m increase in May. Importantly, it rose by a much cooler-than-expected 3.5% y/y in June 2026 (consensus at 3.8%) compared with a hotter 4.2% in May. Core CPI inflation was unchanged in June 2026 (consensus expected a 0.2% increase) versus a 0.2% m/m increase in May. It rose by 2.6% y/y in June 2026 (consensus at 2.8%) compared with 2.9% in May. 

Iranian intransigence But Iran has not honored the terms of the memorandum of understanding (MOU) it signed with the US, which required them to open the Strait of Hormuz with no tolls or fees, forsake their desire to build a nuclear bomb, and turn over their enriched uranium. Over the past fortnight, the US has attempted to enforce the terms of the MOU militarily, and WTI and gas prices have risen by 22% to $82 per barrel and 5% to $3.98 per gallon, respectively. 

What should the Fed do? In our view, the Federal Reserve should be on hold for the balance of 2026, successfully looking through the energy supply shock. But several members of the Fed’s Board of Governors and the 12 regional presidents have said in recent days that they favor hiking interest rates, perhaps at the July 29 or September 16 FOMC meetings. We believe that would be a monetary policy mistake, as hiking rates would do nothing to bring Iran to heel and lower energy prices. 

Equities always test a new Fed Chair While the Fed’s leadership transition is complete, its five task forces have just been staffed with 15 independent all-stars, so the direction and pace of the Fed’s anticipated regime change remain uncertain. Chair Kevin Warsh successfully navigated his first set of Humphrey-Hawkins meetings before the House Financial Services and the Senate Banking committees in Congress this week, but his first Jackson Hole keynote speech at the Fed’s annual monetary policy symposium is still ahead of us on August 28. So, we’re bracing for additional Fed-related financial-market volatility in coming months.

Outlook for stronger growth and slower inflation The liquidity, equity, and fixed income investment professionals who comprise Federated Hermes’s macroeconomic policy committee met last Wednesday to discuss the ongoing conflict with Iran, the leadership and monetary policy transition at the Federal Reserve under new Chair Kevin Warsh, and the possible impact on the economy and financial markets. 

First quarter 2026 GDP was revised up from a gain of 1.6% q/q to a stronger-than-expected final increase of 2.1%, versus a fourth-quarter gain of 0.5% q/q and much stronger third- and second-quarter gains of 4.4% (the strongest quarterly growth in two years) and 3.8%, respectively. Less imports and a downward revision in inventory liquidation during the first quarter accounted for most of the improvement.   

• The trade deficit widened to a 14-month high in May. As a result, we reduced our forecast for second quarter of 2026 GDP growth from 3.0% to 2.7%, while the Blue-Chip consensus raised its estimate from 1.7% to 2.1% (within a range of 1.2% to 2.8%). The Atlanta Fed lowered its GDPNow tracking estimate from 3.8% to 1.3%.
• The conflict with Iran has reignited, which has elevated energy prices over the past fortnight. So, we ticked our forecast for third quarter of 2026 GDP growth down from 3.2% to 3.1%, while the Blue-Chip consensus raised its estimate from 1.7% to 1.9% (within a range of 0.8% to 2.7%).
• We expect the strength in consumer spending over the past several months to continue through the Back-to-School and Christmas seasons. So, we kept our forecast for fourth quarter of 2026 GDP growth unchanged at 3.2%, while the Blue-Chip consensus similarly kept its estimate unchanged at 1.9% (within a range of 0.7% to 2.7%).
• Similarly, we kept our estimate for full-year 2026 GDP growth unchanged at 2.5%, while the Blue Chip consensus raised its estimate from 2.0% to 2.1% (within a range of 1.8% to 2.4%).
• With the improvement in energy prices and the sharp reduction in nominal and core inflation in June, we reduced our year-end 2026 estimate for core CPI inflation from 2.9% to 2.8% (compared with core CPI inflation of 2.6% y/y in June 2026), while the Blue Chip consensus hiked its forecast from 3.4% to 3.5% (within a range of 3.2% to 3.8%). We also left our year-end 2026 estimate for core PCE inflation unchanged at 3.0% (compared with core PCE inflation of 3.4% y/y in May 2026), while the Blue Chip raised its estimate from 3.4% to 3.6% (within a range of 3.4% to 3.8%).
• The labor market, consumer spending and manufacturing activity have all improved noticeably in recent months, a trend we expect to continue into next year. So, we kept our full-year 2027 GDP growth estimate unchanged at an elevated 3.0%, while the Blue-Chip consensus also kept its estimate unchanged at 2.0% (within a range of 1.4% to 2.6%).
• We reduced our year-end 2027 estimate for core CPI inflation from 2.4% to 2.3%, while the Blue-Chip consensus raised its estimate from 2.5% to 2.6% (within a range of 2.1% to 3.3%). We left our year-end 2027 estimate for core PCE inflation unchanged at 2.5%, while the Blue-Chip consensus also left its estimate unchanged at 2.5% (within a range of 2.1% to 3.2%).

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