Today’s ISM services index appears to have given risk sentiment a lift, but caution is understandable. A long, protracted military campaign involving disrupted energy flows will lift energy costs and boost inflation readings through the summer. However, it will also squeeze consumer spending power, with households having to spend more on motor fuel, heating and electricity. The corporate sector, which is bearing the brunt of tariffs, will also face more cost increases.
The longer energy costs stay elevated, the greater the risk it becomes demand destructive, which dampens inflation pressures over the medium to longer term. The Fed will likely be nervous about headline inflation initially, but if the core metrics (excluding food and energy) start to cool, officials will likely become more comfortable cutting interest rates a couple of times in the second half of the year.