Inflation remains front and center as the Fed holds

Prices that have run hot lately have markets anticipating a second 2026 rate hike in December, a view that Vanguard shares. From there, however, we expect less tightening will be needed than markets expect, owing to shock-driven inflation that is set to moderate by the second half of 2027. The key to whether the Fed remains on hold fully in 2027 will be whether near-term data allow the moderating-inflation path to unfold and enable the Fed to maintain its bias toward patience.

Core inflation today reflects three outsize recent shocks: tariffs, energy prices, and AI-related demand. Excluding these effects, we see underlying inflation as being much closer to the Fed’s 2% target.

Tariffs represent the most immediate driver of disinflation as price increases from early 2025 will roll off precipitously by April and May of 2027. That mechanical effect alone should have core inflation, as measured by the Personal Consumption Expenditures (PCE) price index, approaching 2.5% by late spring—a meaningful decline from current levels.

Oil prices, which have remained stubbornly elevated around $100 per barrel for much of this year, will take longer to moderate. Absent any new and sustained upward price pressure, however, oil prices’ contributions to inflation will remain limited.

AI’s impact remains less certain in the near term and represents a key watch factor. That said, we expect AI-related inflation to continue to contribute 30 to 40 basis points to year-over-year core inflation through 2027 before moderating in 2028.

This breakdown offers a different perspective on the evolution of inflation in recent years. While overall inflation has moderated little, its composition has indeed shifted. The underlying economy may be performing largely as the Fed intends, with modest policy adjustments keeping it on track to achieve price stability while maintaining labor market balance.

The challenge for policymakers, and the key risk to our baseline view, is whether underlying inflation reaccelerates before these shocks fade. Recent economic momentum has been noteworthy, and the extraordinary AI buildout risks the need for monetary policy tightening beyond our baseline.

That baseline outlook anticipates core PCE inflation moving toward the Fed’s target, ending 2027 at around 2.5%. Such an evolution would support our forecast for one additional Fed rate increase before year-end 2026, with the Fed well-positioned to remain on hold in 2027. The data over the next several months will test our conviction.