While the May CPI report showed a headline jump of 4.17% year-over-year (the highest since April 2023), driven largely by a 7.0% spike in gasoline prices, Kelly argues May likely represents the peak of this current cycle. He outlines four distinct deflationary forces set to drag CPI down to 3.3% by December 2026 and 1.8% by May 2027:
Energy Supply Rebound: Gasoline prices peaked at $4.56 in late May and have already receded. Crucially, Kelly bases further energy deflation on the assumption that the recent U.S.-Iran interim peace deal keeps the Strait of Hormuz open, normalizing global oil flow alongside continued SPR rollouts.
Tariff Rollbacks: Following the Supreme Court and Court of International Trade rulings against IEEPA and Section 122 unilateral tariffs, average gross tariff rates have fallen from 11.5% in late 2025 to 7.8% over the last three months. Even with the administration proposing new Section 301 tariffs (10% to 12.5% on select countries), Kelly models a stabilized 7.5% average tariff rate by Q4, mitigating retail price pressures.
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Shelter Normalization: The housing market lag is finally catching up. May data showed a clean reading (free of last autumn's government shutdown distortions) with rent and OER (Owners' Equivalent Rent) cooling to 2.9% and 3.3% respectively. High rental vacancies (7.3%, a post-2017 high) and down-trending forward indicators (Zillow/CoStar pointing to -1.7% to +1.8% on new leases) ensure structural shelter deflation into 2027.
Absent Wage-Price Spirals: Despite hot headline numbers, average hourly earnings rose just 3.45% in May—marking the second-smallest gain in five years and a second consecutive month of negative real wage growth. Low union density (under 6% of the private sector) keeps labor leverage minimal.
2. The Inflation Gauge Matrix
With Chairman Warsh taking the helm, the debate over which inflation metric matters has intensified. During his confirmation hearings, Warsh signaled a strong preference for "trimmed mean" calculations.
Kelly contrasts the May layout across the primary metrics to illustrate the policy dilemma:
Inflation Metric
May Y/Y Print
Macro Interpretation & Characteristics
Headline CPI
4.2%
Highest visibility; accurately reflects the immediate cost-of-living squeeze on households (food/energy).
Headline PCE
4.0%
The Fed's official target; utilizes chain-weighting to account for consumer substitution behavior.
Core PCE
3.3%
Strips out volatile food and energy components to identify underlying stickiness.
Dallas Fed Trimmed Mean PCE
2.4%
Warsh's preferred metric; cuts off extreme outliers on both tails. Most stable, but unlikely to drop below 2% even by 2027.
The Takeaway on Metrics: While Warsh notes the trimmed mean shows structural improvement, Kelly warns that relying solely on it is dangerous. For forecasting, one must look at actual administrative policies (tariffs, supply chains); for assessing economic health, the average family cannot simply "trim" food and energy out of their reality.
3. Fed Policy: No Cuts, No Hikes, Less Activism
Looking ahead to the upcoming FOMC meeting, Kelly expects the Fed to bump up its growth and inflation projections while pulling down unemployment estimates.
The Dot Plot Shift: The Fed will likely completely remove their expectation of any interest rate cuts for 2026.
The Consensus Builder: Despite dovish confirmation hints, Chairman Warsh is expected to vote with the hawkish majority to build committee consensus. However, he will likely successfully block the additional rate hikes currently being priced into the futures market.
A Shift to Inaction: Kelly anticipates Warsh will champion a regime of Fed non-activism. As long as growth and inflation trend slowly downward into 2027, the central bank will avoid micromanaging the economic descent. Furthermore, with booming AI capital expenditure, robust consumer spending, and equities on track for a fourth consecutive positive year, cutting rates right now would only serve to fund market speculation and inflate dangerous asset bubbles.
4. Portfolio Implications
With monetary policy entering a period of passive gridlock, Kelly highlights a fundamental shift in fixed income mechanics:
The Sovereign Debt Premium: The direction of long-term yields will increasingly be driven by fiscal policy rather than monetary policy.
The accumulation of staggering U.S. government debt will exert a structural upward pressure on long bonds (steepening the curve). Investors shouldn't ditch high-quality fixed income, but they must reset expectations: bonds should be held tightly for income and diversification, not for capital gains via yield compression.
Capital Group: 2026 Midyear Outlook | 16 July 2026
1. Executive Briefing TL;DR The Core Thesis: The 2026 mid year macroeconomic landscape exhibits resilient trend GDP growth of approximately 2%, driven primarily by an unprecedented artificial intelligence capital expenditure boom and robus…