The Federal Reserve's Initial July Inflation Forecast Looks Fantastic on the Surface, but Something Sinister Lurks in the Details

For much of the last four years, the evolution of artificial intelligence (AI) has dominated Wall Street headlines. Otherworldly growth prospects for AI have lifted the Dow Jones Industrial Average (DJINDICES: ^DJI), S&P 500 (SNPINDEX: ^GSPC), and Nasdaq Composite (NASDAQINDEX: ^IXIC) to new heights.

But a strong argument can be made that inflation has surpassed AI as the stock market's No. 1 talking point, and its biggest risk. While the Federal Reserve's initial July inflation forecast appears promising on the surface, something sinister lurks in the details.

Fed Chair Kevin Warsh delivering remarks. Image source: Official Federal Reserve Photo.

A historic energy supply disruption created havoc in the energy market

In February, trailing 12-month (TTM) U.S. inflation clocked in at a relatively modest 2.4%. Although the stickiness of President Donald Trump's tariffs within the goods sector was reflected in this figure, a 2.4% inflation rate appeared to support further rate cuts by the Fed.

However, the Trump-led Iran war threw this playbook out the window. Shortly after military operations commenced against Iran on Feb. 28, the latter closed the Strait of Hormuz to virtually all commercial vessels. This action halted the daily movement of approximately 20 million barrels of petroleum liquids (20% of the world's supply).

BREAKING: May CPI inflation rises to 4.2%, the highest level since April 2023.

Core CPI inflation also rises to 2.9%, the highest since September 2025.

Inflation in the US is officially back above 4% and more than double the Fed's target.

Odds of Fed rate hikes are rising.

-- The Kobeissi Letter (@KobeissiLetter) June 10, 2026

The impact of this historic supply disruption was unmistakable in energy markets. Crude oil prices surged 70% in a matter of weeks, with gas prices climbing at the fastest pace in more than three decades. Energy commodity price hikes almost singlehandedly increased U.S. TTM inflation from 2.4% in February to a three-year high of 4.2% in May.

But according to the latest forecast from the Federal Reserve Bank of Cleveland, partial relief awaits on the inflation front.

Image source: Getty Images.

The inflation devil is in the details

Every weekday, the Cleveland Fed's Inflation Nowcasting tool updates front- and forward-month inflation forecasts (when applicable) to account for newly released economic data. The latest update gave investors an initial look at the July inflation forecast.

The silver lining for consumers and Wall Street is that crude oil prices have plunged in the wake of peace talks between the U.S. and Iran. West Texas Intermediate crude oil falling back below $70/barrel has the Cleveland Fed forecasting TTM inflation of 3.92% in June and 3.49% in July (as of the July 2 update).

But the inflation devil is in the details. While broad inflation is projected to notably decline in June and July, Core Personal Consumption Expenditures (PCE), which excludes volatile food and energy costs, is projected to rise from 3.4% in May to 3.43% in June and 3.47% in July.

The Fed's preferred measure of inflation (Core PCE) moved up to 3.4% in May, the highest level since October 2023.

This was the 63rd consecutive reading above the Fed's 2% target level.

"We've missed for 5 years. And we're gonna fix that."-Kevin Warsh last week pic.twitter.com/Wtayfgt8sq

-- Charlie Bilello (@charliebilello) June 25, 2026

A modest seven-basis-point increase in Core PCE might not sound like much, but it's direct evidence that the inflationary effects of the Iran war have spilled over into the broader economy. In other words, we're not just talking about higher fuel prices. The adverse effects of higher transportation and production costs for several sectors and industries are increasing prices for consumers and businesses outside the energy sector.

The latest Fed inflation update adds fuel to the fire that Fed Chair Kevin Warsh and the other 11 Federal Open Market Committee policymakers seriously need to consider hiking interest rates to stabilize prices. Higher borrowing costs can slow the AI data center build-out, which could prove disastrous for a stock market that's priced for perfection.

Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.