Before the release of the crucial nonfarm payrolls report on July 2, U.S. financial markets faced a hawkish shadow of rate-hike expectations. The market consensus at the time was exceptionally solid. On the one hand, the supply chain crisis triggered by the U.S.–Iran conflict exposed the domestic economy to severe inflationary pressures, potentially requiring rate hikes to cool things down. On the other hand, the labor market performed well, with the real economy demonstrating extraordinary resilience against high interest rates.

Specifically, according to the June report from the Bureau of Labor Statistics (BLS), the U.S. Consumer Price Index (CPI) surged to 4.2% year-over-year in May, driven by a 23.5% spike in energy prices, which alone accounted for over 60% of the headline CPI increase that month. Moreover, data from the Bureau of Economic Analysis (BEA), in which the Personal Consumption Expenditures (PCE) price index that serves as the Federal Reserve's primary policy anchor, showed that May PCE rose 0.4% month-over-month and 4.1% year-over-year. Core PCE, which excludes food and energy, increased 0.3% month-over-month and 3.4% year-over-year, both significantly deviating from the Fed's 2% long-term target.

At the same time, BLS data published for May and June showed that nonfarm payrolls maintained steady monthly gains of roughly 160,000 to 180,000. This momentum led Wall Street to broadly believe that U.S. businesses were continuing to hire aggressively despite high interest rates of 3.50%–3.75%. The official unemployment rate had consolidated within a 4.1%–4.3% range for an extended period, a healthy state that economists consider extremely close to full employment. Furthermore, average hourly earnings growth remained elevated at 3.8%–4.0% year-over-year. In the eyes of the Fed, such strong wage growth implied that consumer purchasing power remained robust. With no signs of widespread layoffs and wage growth threatening to trigger a vicious wage-price spiral, the market concluded that the Fed would proactively cool the overheated labor market via interest rate hikes without worrying about pushing the economy into recession.

This elevated inflation and strong employment coincided with the swearing-in of new Fed Chair Kevin Warsh on May 22. At the June Federal Open Market Committee (FOMC) meeting he chaired, although the target range for the federal funds rate was temporarily maintained at 3.50%–3.75%, officials aggressively raised their 2026 PCE and core PCE inflation forecasts to 3.6% and 3.3%, respectively. Among the 18 FOMC participants, nine explicitly dot-plotted at least one rate hike before the end of the year, reigniting market fear of further tightening. Warsh subsequently signaled a firm, hawkish stance again on July 1, emphasizing that the Fed would under no circumstances tolerate inflation above its 2% target. This sequence of hawkish signals pushed market sentiment to extreme tension. Before the latest jobs report was released, CME interest rate futures reflected a near 75% probability of a September rate hike, and U.S. financial markets began betting heavily on the Fed embarking on a renewed rate-hiking path.

That policy narrative was shattered on July 2 when the June employment report was released. Nonfarm payrolls increased by just about 57,000, roughly half of market expectations, while combined job gains for the prior two months were revised down by approximately 74,000. Although the unemployment rate edged down from 4.3% to 4.2%, the labor force participation rate dropped 0.3 percentage points to 61.5%, and the employment-to-population ratio fell to 59.0%. Long-term unemployed individuals reached about 1.9 million, an increase of nearly 286,000 from a year earlier, accounting for 27.3% of total unemployment. Meanwhile, the leisure and hospitality sector shed 61,000 jobs in a single month, leaving employment growth increasingly concentrated in a few defensive sectors like healthcare and social assistance. Following the release of the employment data, the implied probability of a July rate hike plummeted below 20%, while the probability of a September hike dropped from around 75% to roughly 60%. This shift indicates that the market began realizing the U.S. labor market might not be as solid as previously thought, potentially shifting the Fed's monetary policy trade-offs.

How should one interpret the current shifts in macroeconomic data and market rate expectations?

The Fed's mandate is to achieve price stability and maximum employment. According to the updated Statement on Longer-Run Goals and Monetary Policy Strategy revised in January 2025, when conflicts arise between maximum employment and price stability, the Fed's decision-making must systematically consider two core variables, i.e., the shortfalls or deviations of key indicators from their long-term targets, and the respective time horizons required to return to levels consistent with its dual mandate.

In the past, because headline CPI and core PCE price indexes persistently and significantly exceeded the 2% alarm threshold while the official unemployment rate consolidated within a narrow range near historical lows of 4.3%, the Fed clearly treated inflation containment as an overriding, exclusive priority in its policy considerations.

However, behind this decision-making logic was the assumption that inflation possessed broad-based, persistent demand-pull characteristics while the labor market retained sufficient resilience. Recent shifts in macroeconomic data suggest that both premises are beginning to loosen.

On the one hand, volatility in energy prices has become the primary driver pushing up price levels, giving inflation a more structural and transient characteristic. On the other hand, the marked slowdown in job growth, declining labor force participation, and rising long-term unemployment indicate that the intrinsic momentum of the labor market is weakening. In this context, relying solely on headline inflation as a policy anchor fails to capture the overall state of the economy. The Fed must address critical questions of whether current inflationary pressures are sustainable, and whether the true degree of labor market tightness is obscured by a low unemployment rate. Only after clarifying the structural sources of inflation and the actual state of employment can officials assess whether the policy scales need to rebalance.

Looking at the current structure of U.S. inflation, recent upward price pressure has stemmed primarily from energy. In May, energy prices rose 3.9% month-over-month, contributing over 60% of the 0.6% monthly gain in headline CPI, with gasoline prices surging 7.0%. In contrast, core CPI excluding food and energy rose just 0.2% month-over-month. The U.S.–Iran conflict and transport risks in the Strait of Hormuz drove up crude oil, gasoline, and logistics costs, which is a classic external supply shock rather than an indicator of overheating domestic income and consumption.

Signals of easing tensions during early U.S.–Iran negotiations in mid-June caused international crude oil prices to plunge by approximately 21% at one point, returning to pre-conflict levels by early July. New York Fed President John Williams also expressed being slightly more optimistic about the near-term inflation outlook. Driven by lower energy prices, U.S. inflation cooled noticeably in June, with CPI rising 3.5% year-over-year, down 0.7 percentage points from the prior month, and declined 0.4% month-over-month. At the same time, core CPI rose 2.6% year-over-year and was flat month-over-month. However, renewed military strikes between the U.S. and Iran on July 8 sent international oil prices surging 6% in a single trading session, an indication that energy inflation has not fully subsided and that its trajectory remains volatile and heavily dependent on geopolitical maneuvering.

It is worth noting that due to oil oversupply, crude prices would be expected to trend lower over the long term absent geopolitical factors. Furthermore, due to the shale revolution, U.S. energy self-sufficiency has strengthened substantially over the years, reducing the relative share of energy in consumer expenditure and corporate costs while enhancing the financial system's capacity to absorb oil price volatility. These factors have all mitigated the transmission intensity of rising energy prices to headline inflation and broader economic activity. Consequently, even with significant short-term oil price swings, the direct impact on inflation may not be as severe as in past energy crises. According to current Fed macroeconomic models, every USD 10 per barrel increase in international crude oil prices directly boosts U.S. headline CPI by approximately 0.2 percentage points.

Other than energy prices, housing and core services remain the primary endogenous sources of U.S. inflation. However, June data indicates that sticky price dynamics in these components are gradually unwinding. Housing carries a weighting of roughly 35.1% in the CPI and rose 3.3% year-over-year in June. A rough calculation based on its weighting and annual gain suggests it contributed about 1.16 percentage points to year-over-year CPI, accounting for approximately 33.1% of headline inflation. Looking closer, rent of primary residence rose 2.8% year-over-year, while owners' equivalent rent (OER) increased 3.3%. Meanwhile, shelter prices edged up just 0.1% month-over-month, the smallest gain since January 2021, indicating that while housing inflation remains elevated, its marginal upside momentum has slowed markedly. Notably, rent and OER exhibit significant statistical lag. Even as spot prices on newly signed market leases cool down, it takes time for these declines to fully feed through into the CPI, meaning housing will likely remain a key support for core inflation in the coming months.

At the same time, stickiness in core services inflation is diminishing. In June, non-energy services prices were flat month-over-month and rose 3.2% year-over-year, decelerating from 3.4% in May. Growth in medical care services narrowed, transportation services slowed significantly, and motor vehicle insurance inflation pulled back from previous highs, with price gains persisting primarily in select categories like recreation. On a year-over-year basis, core services excluding shelter contributed approximately 0.76 percentage points to headline CPI, or about 21.7%. However, airline fares surged 26.5% year-over-year, remaining heavily impacted by earlier increases in fuel and transport costs. Mechanically stripping out energy-sensitive airline fares leaves the contribution of remaining non-housing core services to headline inflation at roughly 0.47 percentage points. Combined, housing and non-housing core services, excluding airline fares, contributed about 1.63 percentage points, or 46.5% of total headline inflation in June; here both absolute contributions and short-term momentum down from May.

An analysis of the June inflation structure reveals that the largest single factor pushing up U.S. headline inflation and driving prices off their normal trajectory remains the U.S.–Iran conflict and its resulting external energy shock. In June, U.S. energy prices were still up 15.7% year-over-year, lifting headline CPI growth to 3.5%. However, as gasoline prices fell 9.7% month-over-month, headline CPI turned negative at -0.4% month-over-month, proving that recent inflation swings have been overwhelmingly energy-driven. Meanwhile, core CPI excluding food and energy rose 2.6% year-over-year, with housing and non-energy services up 3.3% and 3.2% year-over-year, respectively. This indicates that endogenous inflation driven by domestic rents, wages, and service demand has not fully normalized. From a marginal trend perspective, however, the annualized three-month rate of core CPI has slowed to roughly 2.4%, and month-over-month growth stalled completely in June. This suggests that the near-term pace of endogenous inflation is nearing the Fed's 2% long-term target as measured by PCE. In other words, the primary pressure driving U.S. inflation above policy targets is increasingly coming from external energy shocks rather than broad-based domestic overheating.

By contrast, the weakening of the labor market may prove more persistent. The U.S. is not currently experiencing mass layoffs. Rather, it has entered a frozen state characterized by low hiring, low layoffs, and low labor mobility. According to the Job Openings and Labor Turnover Survey (JOLTS) released by the BLS on July 1, the layoff rate nationwide remained extremely low at 1.1% in May, confirming that firms are indeed retaining current staff. However, the voluntary quits rate fell below the 2.0% warning threshold, and the hiring rate similarly hovered at multi-year lows. Furthermore, nonfarm payroll gains for April and May 2026 were revised down by 31,000 and 43,000, respectively, a cumulative downward revision of 74,000 that showed muted corporate hiring appetite. On July 8, minutes from the Fed's June FOMC meeting warned that, behind the mask of a seemingly stable overall unemployment rate in mid-2026, the share of individuals unemployed for more than 27 weeks quietly climbed above 20% of total unemployment, indicating that low hiring rates are exacerbating the accumulation of structural unemployment.

Hence, while the labor market appears stable on the surface, it may actually be quite fragile. Citigroup notes that had the participation rate not declined in June, the unemployment rate would be significantly higher assuming constant employment levels. If workers aged 25 to 34 re-enter the workforce later this summer while corporate hiring remains stagnant, the unemployment rate could quickly rise above 4.5%. More alarmingly, labor market adjustments are rarely linear. Businesses typically pull job postings, stop replacing departing staff, cut hours, and drop temporary positions before turning to formal layoffs. By the time the unemployment rate begins to rise noticeably, underlying labor demand may have been weakening for months.

Currently, the sharp divergence between inflation and employment dynamics has thrown interest rate expectations into their most intense swings in recent years, with the Fed, Wall Street investment banks, and retail investors holding differing views on the future path of monetary policy.

The Fed's policy rhetoric remains hawkish. Warsh maintains a firm commitment to the 2% inflation target, while Governor Christopher Waller argues that elevated inflation remains the primary risk facing the U.S. economy. A June survey by the New York Fed showed one-year inflation expectations rising from 3.5% to 3.7% and three-year expectations ticking up from 3.1% to 3.3%, making it impossible for the Fed to prematurely declare victory over inflation. However, hawkish talk does not equate to immediate rate hikes. In a public speech on July 7, Williams noted that monetary policy is currently in a good place, favoring a wait-and-see approach for upcoming data. Taken together, the Fed is far more likely to verbally suppress market expectations of early rate cuts while staying on the sidelines operationally.

According to a Reuters survey of economists conducted between June 23 and June 25, over three-quarters of respondents expect the Fed to keep interest rates unchanged for the remainder of the year, forming the current macroeconomic consensus among academics. However, sell-side forecasts display fierce polarization. Bank of America and Deutsche Bank, pointing to high-inflation tail risks that pushed two-year Treasury yields to 4.55% at one point, aggressively project that the Fed will raise rates by an additional 75 and 50 basis points, respectively, before year-end to forcefully head off supply-side secondary inflation. Conversely, Citigroup, citing real-economy debt strain as U.S. auto loan default rates spiked to a record extreme of 5.60% in the first quarter of 2026, argues that endogenous aggregate demand has peaked and remains convinced the Fed will deliver three consecutive 25-basis-point insurance rate cuts in October, December, and January 2027.

Compared to academics and investment banks, ordinary investors were much more uneasy about interest rates. Following the July 2 nonfarm payrolls release, a frantic buying spree in the Treasury market forcefully dialed back rate-hike bets. However, as the U.S.–Iran conflict escalated again on July 8, surging oil prices swiftly hijacked market sentiment, driving the 10-year U.S. Treasury yield up 15 basis points to a high of 4.35% within hours.

Researchers at ANBOUND note that maintaining interest rates unchanged for the remainder of the year remains the single highest-probability path. However, the necessity for renewed rate hikes is diminishing, while the likelihood that the next policy move will ultimately be a rate cut is rising. The reason is not that inflation has returned to 2%, but that current price pressures are increasingly concentrated in structural components such as energy, housing, and services, particularly external supply shocks against which rate hikes offer limited effectiveness. Meanwhile, the negative impacts of low hiring, high interest rates, and industrial restructuring on employment continue to accumulate. The Fed will wait for further CPI, PCE, and labor market data in the near term. Yet, if coming months show energy shocks receding and core inflation gradually cooling alongside persistent weakness in payrolls and an upward drift in unemployment as participation recovers, the policy balance will inevitably lean toward employment. At that stage, the real question facing the Fed will no longer be whether further inflation suppression is required, but whether maintaining elevated rates is causing unnecessary job losses. In this sense, anticipating a direction based on shifting risk balances brings one closer to the true evolution of policy risk than simply betting on rate hikes based on current inflation headlines.

Final analysis conclusion:
U.S. inflationary pressures remain elevated, but incremental gains are increasingly concentrated in energy shocks, lagged housing costs, and service price increases. In particular, the external energy shock resulting from the U.S.–Iran conflict represents the single biggest obstacle preventing U.S. prices from returning to a normal trajectory. By contrast, the labor market is transitioning from surface stability into a frozen state marked by sluggish hiring, low turnover, and rising long-term unemployment. Holding rates steady through year-end remains the most probable policy path, but the Fed's risk weighting will likely orient incrementally from inflation toward employment and economic growth. Ultimately, the next interest rate adjustment is more likely to be a precautionary rate cut rather than the restart of a rate-hiking cycle.