As expected during its July meeting, the Federal Reserve announced that it is keeping its overnight policy rate unchanged (3.50-3.75%). Risk assets sold off after the announcement and longer-dated US Treasury yields moved higher. Broad-based US equity indices all finished down at least 1.5% at market close. The 5-year US Treasury yield increased 5 bps to 4.4%, the 10-year US Treasury yield increased 7 bps to 4.7% and the 30-year US Treasury yield jumped 12 bps to 5.2%.
Why did equities and bonds sell off after the announcement?
With inflation running hotter than expected so far in 2026, the Fed's decision to keep rates unchanged has added fuel to the idea that inflation is becoming more entrenched in the United States. Inflation has been stubbornly above the Fed's 2% target since the COVID-19 pandemic, and while there has been great progress in slowing the acceleration of price growth in recent years, that progress has reversed course somewhat in 2026.
Additionally, the combination of higher inflation with low and stable unemployment led markets to expect the Fed to adopt a more restrictive mindset regarding monetary policy. Yesterday's Fed decision (and lack of forward guidance in its press release and press conference) did little to convince markets that the Fed will be "ahead of the curve" when it comes to taming inflation.
Will the Fed raise rates at all in 2026?
The current expectation is that the Fed will increase its overnight policy rate by 25 bps before the end of the calendar year. Markets are currently pricing in one rate hike in September 2026. Should inflation increase or remain near its current level over the next couple of months, a September rate hike is probable.
That said, it is important to note that June's inflation reading was much softer than what markets anticipated. And while that is just one month of data, there is an expectation that inflation will soften further in the months ahead. Inflation will not reach the Fed's 2% target in 2026, but the current expectation is that inflation will drop at least another 50 bps between now and the end of this year. Should this expectation remain intact over the next couple of months, the Fed might decide to keep rates unchanged in September (and possibly for the remainder of the year).
Why is inflation expected to decline in the second half of 2026?
There are a number of reasons to believe that inflation will move lower in the second half of this year.
For one, housing — the largest component of the inflation index — is expected to show slower and slower price growth in the months ahead. This category has been in disinflation territory for many months now, and that trend is expected to continue.
Additionally, consumer spending is expected to slow somewhat in the back half of 2026. (Note: Consumer spending is still expected to grow, just at a slower pace than in the first half of the year.) Given that consumer spending makes up nearly 70% of overall US economic activity, slower spending growth should result in softer inflation.
Finally, the run-up in inflation in 2026 can almost entirely be described as "supply driven." In other words, the spikes in energy and goods prices seen in recent months were primarily driven by a lack of supply. Historically speaking, supply shortages in energy and goods are typically short-lived phenomena, lasting months or quarters, not years. Why? 1) If prices rise too much, demand eventually slows and better matches supply. 2) If suppliers profit handsomely from excess demand, suppliers will ramp up production to better match demand. The point is that higher prices in goods and energy typically result in an improved balance between supply and demand and slower inflation. This dynamic — at least to some extent — is what many economists expect to occur in the months ahead.
Predicting monetary policy decisions is always a challenging endeavor. In the current environment, even more so. Simply put, there are too many uncertainties related to energy and goods supplies to know what monetary policy decisions (if any) the Fed will make between now and the end of 2026. However, it's fair to assume that: 1) An increase in inflation will lead to a rate hike in 2026, and 2) A meaningful decline in inflation may keep rates unchanged for the remainder of the year, even if inflation remains well above the Fed's 2% target.
This is a very dynamic situation and we will continue to keep you posted as facts and circumstances change.
This report and the analysis contained herein were prepared exclusively by the Wealth Management division of Enterprise Bank & Trust and reflect our internal market views.
Investments are: *Not FDIC insured *May lose value *Not financial institution guaranteed *Not a deposit *Not insured by any federal government agency.
