Stocks are near record highs, but weakening retail sales and rising inflation expectations have put the Fed in an increasingly uncomfortable policy bind.
KEY TAKEAWAYS
The stock market and the consumer economy are sending very different messages. The S&P 500 is near record highs while households are dealing with higher prices, high borrowing costs, geopolitical uncertainty, and deteriorating confidence.
July retail sales suggest the consumer is genuinely pulling back. Weakness extended beyond volatile categories, including the retail-sales control group that feeds into GDP calculations.
Consumer sentiment deteriorated sharply, particularly among economically vulnerable groups. Lower-income, older, and non-college-educated consumers appear especially exposed to further losses of purchasing power.
Weak consumption would normally be a disinflationary signal and an argument for easier monetary policy. The complication is that near-term inflation expectations moved higher at the same time.
The Fed's two mandates are increasingly pulling in opposite directions. Supporting employment and consumption argues for easing, while protecting inflation credibility argues for caution.
MY HOT TAKES
The Fed does not simply have a difficult decision--it has two increasingly incompatible problems. Almost any policy choice that helps one side of the mandate risks making the other side worse.
Bad economic news may no longer automatically be good news for markets. If weakening growth arrives alongside rising inflation expectations, the familiar “weak data equals Fed cuts” trade becomes far less dependable.
The consumer may be the more important signal than the stock index right now. Record equity prices can coexist with substantial economic stress, particularly when that stress is concentrated among households with less financial cushion.
Inflation expectations matter because they can eventually influence actual inflation. The greatest risk is not one bad survey reading but households and workers changing spending and wage behavior because they believe inflation will persist.
The divergence between market prices and economic mood deserves attention rather than an automatic bearish conclusion. Stocks can remain near records, but investors should understand that the economic foundation beneath those records has become substantially more complicated.
You can quote me: “Every option on the table solves one problem while making the other one worse, and there's no data release on the calendar that resolves that tension cleanly.”
Overcast forecast. Stocks marched to all-time highs last week, but for some strange reason it did not feel as exciting as usual. Not that 7816 is a big round number for the S&P, but it was factually yet another all-time high for the index. If I hadn’t told you that, or you hadn’t seen it on the bottom of every news channel screen, I would bet that you would not have guessed that stocks have been surging.
There is a bit of war raging in the Persian Gulf and the eye of the storm seems to be right over a recently discovered-by-social-media strait that carries some 20% of the world's oil supply and countless other critical commodities–from aluminum to fertilizer, to who knows what else. You probably don’t buy crude oil or even fertilizer, but everything else you buy has been affected by it. Some things by just a little bit, and others by quite a bit. Whichever, it is enough to make one less than comfortable with prices already at what feel like nosebleed levels.
The events in the middle east have edged inflation higher to the point where prices of goods and services are growing faster than your wages. That means–in plain english–that you won’t even feel the raise you just got–it’s already been spent on the inflation you have no control over. The Fed is not happy with this and it has pledged with all its might to fight it, which translates to higher interest rates. Even without the Fed, interest rates are high, which can be a problem if you are looking to borrow money for a mortgage, car loan, or you have a variable rate loan.
How do you feel about all that? Not too great, right? But don’t worry, the chiron on the screen says that stocks just hit a new record high, and there is a video loop repeating showing some guy with wild hair celebrating on the floor of the iconic New York stock exchange (I know that guy–he’s real and he’s also an icon 😉).
As you probably know, Wall Street loves a clean story, and as we walk through the dreary drizzle this morning to start the week–it doesn't have one. Last week ended with a bit of a bang. Retail sales posted their worst month in over a year. Consumer sentiment cratered right along with it. By the old playbook, that's the setup for a Fed pivot–growth slows, the central bank eases, everybody exhales. Except…there was a rub. The same survey that told us Americans are miserable also told us they think prices are about to run hotter, not cooler. That's not a green light for the Fed. That's a trap door.
Let's start with the number that got the headlines. Retail sales fell -.06% of a percent in July, the sharpest monthly drop in more than a year and a clean miss against expectations for a modest gain. That alone would be a rough print. But the detail underneath is worse than the headline, because it tells you this wasn't just gas prices doing the damage. 👀 Strip out autos and gasoline and sales still fell -0.2%. Strip out food services, building materials, autos, and gasoline –the version of retail sales that actually feeds into GDP math, and spending was down -0.4%, the weakest reading since the start of last year. Nonstore retailers, essentially the online shopping category, led the slide, and auto dealers weren't far behind. None of that reads like a one-month wobble caused by a single volatile category. It reads like…payback. Consumers front-loaded spending earlier this year, whether chasing deals, beating tariff-driven price hikes, or just spending while they still felt flush, and now the bill is coming due in the form of a pulled-back household. That's the mechanism, not just the symptom. And it's the kind of thing that shows up first in the parts of the economy with the least cushion–lower-income households, credit-dependent households, the bottom leg of the K that's been quietly diverging from the top for a while now.
There's a second-order effect worth sitting with here, because it's the piece that connects spending to wages and eventually loops back to the Fed. When consumption weakens the way it just did, it doesn't stay contained to retailers' quarterly numbers. Softer sales eventually show up as softer hiring intentions, thinner overtime, fewer promotions, less pricing power for the businesses selling into a pulled-back consumer. That's normally the disinflationary path, weaker demand cools the economy, which cools wage growth, which cools inflation. It's the textbook mechanism, and it's exactly what the Fed would want to see if inflation expectations were behaving themselves. The problem is that this isn't playing out in isolation. It's playing out at the same moment households are telling survey-takers they expect prices to keep climbing. Normally weaker consumption argues for lower rates because it argues for lower inflation down the road. This time, the weakening consumer and the inflation expectations reading are pointing in opposite directions, and that mismatch is the whole story.
If retail sales gave us the what, the University of Michigan's consumer sentiment survey gave us the why. The headline index cratered to just above 51, down from July's final reading in the mid-fifties and a clean miss against expectations that were already sitting a few points higher. That's roughly an 8% one-month decline, and it snapped two straight months of improvement. Both halves of the survey rolled over together–how people feel about today and how people feel about tomorrow–but the forward-looking piece fell harder, which tells you this isn't just grumbling about the price of eggs. It's a loss of confidence in where things are headed. Dig into who drove the decline and the K-shaped story gets another data point: older consumers, lower-income consumers, and those without a college degree posted the sharpest drops, and the survey's own commentary flagged these groups as the ones most exposed to any further erosion in purchasing power. That's not a coincidence. That's the same households showing up in the retail sales data, telling the same story from a different angle. When the group with the least room to absorb a price shock is also the group getting the most pessimistic, that's usually the leading edge, not the lagging one.
Here's where the story stops being simple. If this were only a sentiment collapse and a spending pullback, the read would be straightforward: growth is slowing, the Fed has room to ease, case closed. But buried in that same Michigan survey is the number that should worry the Fed more than the headline index does. One-year inflation expectations ticked up, not down, landing meaningfully above where they sat before this year's geopolitical flare-up rattled energy markets. That's the opposite of what you'd want to see alongside a sentiment crash. Consumers are telling us, in the same breath, that they're worried about the economy and that they expect prices to keep climbing anyway.
This is where the word "anchored" earns its place in the conversation, because it's the whole ballgame for the Fed. Inflation expectations aren't a forecast. They're an input. If households believe prices are going to keep rising, they don't just sit there and absorb it, they change behavior in ways that make the belief true. Some of that shows up on the spending side, pulling purchases forward while a dollar still buys what they think it'll buy. But the more dangerous channel runs through the labor market. 💡 Workers who expect higher inflation ask for bigger raises to protect their purchasing power. Employers, especially in a tight labor market, grant them rather than lose people. Those higher wage costs get passed back into prices. And the cycle feeds itself–that's called the wage-price spiral, and it's precisely the mechanism the Fed has spent years trying to keep from taking hold. The one number in this report that's keeping the Fed from full-blown alarm is the long-run expectation, the five-to-ten-year view, which has held steady for three straight months. That's the number economists mean when they talk about inflation expectations being "anchored" with households and businesses trusting that whatever happens this year, the Fed gets prices back near target over the long haul. It's still holding. But it's holding at a level that isn't the 2% anchor point the Fed actually wants, and the near-term number just moved in the wrong direction. Anchored isn't the same as comfortable.
Put those two data sets side by side and you can see exactly why the Fed is stuck. The growth signal says ease. Retail sales are weakening, the control group used for GDP tracking just posted its worst reading in over a year, and consumer sentiment just had its worst month in a while. That's the kind of data that, on its own, would have policymakers talking about the timing of the next rate cut, not whether one is coming at all. But the inflation expectations signal says hold, or worse, stay cautious. A Fed that cuts rates into rising near-term inflation expectations risks confirming the exact fear households are already expressing–that the central bank has decided growth matters more than prices, and that inflation is getting a pass. That's the fastest way to un-anchor the long-run number that's currently doing the Fed's work for it. But a Fed that holds rates steady into a weakening consumer, with the labor market already showing cracks, risks being the reason a soft patch turns into something worse. There is no clean read here. Cut, and you validate the inflation fear that shows up in that one-year number. Hold, and you own whatever comes next if the consumer keeps buckling. That's not a policy debate with an obvious answer. That's a genuine bind, and it's the kind of bind that gets papered over in headline coverage that just reports "sentiment falls, Fed expected to ease" without asking what happens if easing is exactly the wrong move at exactly the wrong time.
This is the dual mandate working against itself in real time. The employment side of the Fed's job is telling policymakers to worry about a softening consumer and, by extension, a softening labor market. The price stability side is telling them the public's near-term inflation view just moved the wrong way, and that the wage-price mechanism I walked through above is sitting right there as a live risk, not a theoretical one. Normally those two mandates point in roughly the same direction–cool the economy to cool inflation, or support the economy because inflation is contained. Right now they're pulling apart. Every option on the table solves one problem while making the other one worse, and there's no data release on the calendar that resolves that tension cleanly. That is what it means for the Fed to actually be stuck, as opposed to simply cautious.
So we're left with a labor market showing strain, a consumer that's visibly pulling back, and an inflation expectations picture that just made the Fed's job harder instead of easier. The trap door I mentioned at the start isn't a metaphor for effect. It's the actual situation policymakers are standing on. Weak data usually opens a path. This time, the same report that revealed the weakness also closed it back up.
Now, let’s close by clarifying something. There are many folks on Wall Street who don’t like sentiment surveys, because as you know, they have not been very good at predicting things lately. Rightly so, we know that some of them can be biased, reflecting opinion rather than intention. A good way to get some clarity is to ask yourself the same questions that the survey asks. How do your finances compare to a year ago and where do you expect them to be a year out, how do you expect the broader economy to perform over the next year and five years, and whether now is a good time to buy big-ticket items like homes and cars–oh, and where do you expect inflation and unemployment to be? Stocks are right beneath all-time highs.
FRIDAY’S MARKETS
The S&P 500 fell 0.17%, the Nasdaq Composite dropped 0.28%, and the Dow Jones Industrial Average slid 0.20% to 53,732. The 10-year Treasury yield eased to 4.69%. West Texas Intermediate crude rose 1.42% to settle at $82.40 per barrel. Reddit shares jumped roughly 13% ahead of its addition to the S&P 500 next week, while Broadcom fell 6% after analysts questioned a proposed debt-financing vehicle.
NEXT UP
Empire Manufacturing (August) may have slipped to 10.0 from 15.6.
NAHB Housing Market Index (August) probably eased slightly to 33 from 34.
The week ahead will feature still more important, market moving earnings as well as more housing numbers, FOMC Meeting Minutes, Leading Economic Index, and flash PMIs. Check back in if you want to be ahead of the wave.