The whole truth behind the Fed’s rate cuts

Capital market participants have concluded with certainty that the Federal Reserve (Fed) will resume its rate cutting cycle on September 17. The CME Group’s FedWatch Tool even suggests a slight possibility of a surprise half-point (50 basis points) rate cut at the next Federal Open Market Committee (FOMC) meeting. Investors are now pricing in three rate cuts for this year and possibly three more in 2026.¹ In anticipation of easier monetary policy, stocks have reached all-time highs, bond yields have dipped, gold has soared, and the US dollar has weakened.

Headlines forecasting rate cuts focus on the Fed’s struggle to balance its dual policy mandate—price stability and maximum employment—and whether the central bank has lost its independence. Meanwhile, in the background, a slowdown in GDP and potential liquidity squeeze are gathering steam, suggesting the Fed may already be behind the curve.

That makes it critically important for the Fed to begin cutting interest rates now.

The Fed is between a rock and a hard place

It’s not obvious why the Fed should cut rates aggressively. The Fed’s preferred measure of inflation, the Personal Consumption Expenditures (PCE) price index excluding food and energy, increased by 2.9% from a year ago.² That figure is notably above the Fed’s 2% inflation target, and it has been rising in recent months. The Fed has also expressed concern that increasing tariffs could result in short-lived price increases, further aggravating inflation measures.

Meanwhile, the unemployment rate remains at a historically low 4.3%.³ The latest reading from the Federal Reserve Bank of Atlanta GDPNow model estimates solid third quarter growth of 3.1%.⁴ S&P 500 companies delivered 12% year-over-year earnings growth in the second quarter.⁵

Despite fears that increasing tariffs would result in profit margin erosion, the year-over-year change in revenues continues to outpace the year-over-year change in costs by nearly 2%. As a result, S&P 500 operating margins are approaching all-time highs. Consumers continue to spend. And credit markets are showing no signs of stress.

Curiously, Chairman Powell abandoned his inflation-fighting chops in late August at Jackson Hole, choosing to focus instead on the potential downside risks to the labor market, signaling that it may be time to resume the Fed’s rate cutting cycle in September.

This begs the question, is the Fed responding to economic fundamentals or bowing to political pressure from the Trump administration to cut interest rates?

The fragile myth of Fed independence

Concerns over Fed independence are hardly new. The Fed’s independence was undermined the moment it started gobbling up long-term Treasurys and mortgage-backed securities in November 2008 in response to the Global Financial Crisis (GFC).

And there’s a long history of tension between the White House and the Fed. In 1965 at his Texas ranch, President Lyndon Johnson physically pushed then Fed Chairman William McChesney Martin, Jr. in an attempt to intimidate him to reverse the Fed’s decision to raise interest rates. In the run-up to the 1972 election, President Richard Nixon bullied then Fed Chairman Arthur Burns to ease monetary policy. In 1981, then Fed Chairman Paul Volcker viewed President Ronald Reagan’s tax cuts as an obstacle to his monetary policy goals, arguing that the resulting budget deficits were counter-productive to his anti-inflation fight.

Even against this historical backdrop, today the tension over monetary policy is greater, and the outlook is more complicated than ever. Inflation risks are skewed to the upside while labor market risks are tilted to the downside. The dual policy goals of the Fed are in direct conflict, creating a challenging situation for policymakers.

Broad fiscal policy shifts add to the challenges

The Trump administration is reshaping the global trading system. Tougher immigration policy has contributed to a slowdown in labor force growth. Changes to tax, spending, and regulatory policies will have important long-term impacts for the economy and productivity. As Chairman Powell noted in his Jackson Hole speech, “There is significant uncertainty about where all of these policies will eventually settle and what their lasting effects on the economy will be.”⁶

The Fed will never take its inflation fight for granted, but it sounds more confident in the outlook for price increases. Fed officials acknowledge that tariffs have resulted in price increases in some categories of goods. Yet, the Fed suggests that the effects from tariffs on consumer prices are now clearly visible and describes them as relatively short-lived. The Fed is comforted by the fact that longer-term inflation expectations remain well anchored and consistent with its longer-run inflation objective of 2%.

Wisely, the Fed has stopped trying to predict the inflationary impacts from frenetic Trump administration policies, including tariffs, and refocused its attention on changes in longer-term inflation expectations.

This is a good outcome and changes in inflation expectations will be an important signal about the future path of monetary policy.

Jobs falter, Fed blinks

While the Fed is growing more confident about the inflation part of its dual mandate, it’s becoming increasingly more concerned about the labor market portion.

According to the Bureau of Labor Statistics, the US added 911,000 fewer jobs than reported from early 2024 through March. The September 9 report marks the largest preliminary revision on record over the past 25 years. Job growth slowed to an average pace of about 29,000 per month over the past three months, down from 168,000 per month during 2024. In fact, the US economy lost 13,000 jobs in June according to the revised data.

The unemployment rate ticked up to a still respectable 4.3% in August. But Chairman Powell noted at Jackson Hole that the unemployment rate had increased by a full percentage point from its most recent low, a development that historically has not occurred outside of recessions. In another grim sign for the labor market, jobless claim applications increased to their highest level in almost four years on September 11.

Chairman Powell described the labor market as being in a curious kind of balance that results from a slowing in both the supply of and demand for workers. The Fed believes that downside risks to the labor market are rising, which could result in higher layoffs and increasing unemployment.

At the same time, the Fed claims that US economic growth has cooled considerably in the first half of this year to 1.2%, roughly half last year’s 2.5%.

A slowing economy and deteriorating labor market have convinced market participants that the Fed will resume its rate cutting cycle on September 17. Undoubtedly, the Fed will cut the target policy rate as expected.

But the risk of investor disappointment is rising. Capital market price movements in recent weeks may be setting up a classic “buy on the rumor, sell on the news” scenario in the aftermath of the FOMC meeting.

Can’t live with him, can’t live without him

As the Fed grows increasingly uneasy about the labor market, its interdependence with the White House becomes impossible to ignore. The Trump administration and the Fed make for strange bedfellows but, whether they like it or not, they need each other in order to achieve their respective fiscal and monetary policy goals. The irony here is striking.

Without cooperation between the Trump administration and the Fed, the economy faces certain peril. You name it—recession, stagflation, inflation, increasing long-term interest rates, and rising unemployment would all be on the table. Outcomes neither the White House nor the Fed want to see.

In the aftermath of the GFC and COVID pandemic, the relentless simultaneous pursuit of massive government spending and quantitative easing strengthened the bond between fiscal and monetary policy. Today, the Fed’s bloated balance sheet and the government’s poor fiscal position have cemented that connection—fueling friction and a struggle for control between the two institutions.

And investors can’t afford to ignore the powerful relationship between fiscal and monetary policy in today’s increasingly complex environment.

Economic slowdown and liquidity pressures are building

Beyond the tensions between fiscal and monetary policy, quieter threats are emerging that could destabilize financial markets if left unaddressed.

According to Strategas Research Partners, the US budget deficit fell in August, marking the fifth time in the past six months that the deficit came in lower compared to the same month one year ago. During this time, the US budget deficit fell by $227 billion.⁷ Strangely, this has resulted in a modest fiscal drag for the economy and may help partially explain the slowdown.

Until the impact from the One, Big, Beautiful Bill Act flows through to the economy more forcefully, the US budget deficit isn’t deteriorating—but it’s not exactly improving either. This has created a fragile equilibrium in the Treasury market, but without improvements in supply, any type of forced selling could expose the leverage building in the system.

In addition, the Reverse Repo facility (RRP) that was created as part of the Fed’s response to COVID is nearly drained. This is a sign that the excess cash era of COVID is over. Without the RRP, every dollar that goes toward rebuilding the Treasury General Account (TGA) and quantitative tightening (QT) drains liquidity from the financial system. September 15 is corporate Tax Day which will result in companies withdrawing funds from the banking system. A second liquidity drain comes around September 30 as the quarter ends and Reverse Repos terminate. Historically, these transfers tighten financial conditions.

Despite growing friction, the Treasury and Fed must work together to navigate the unexpected fiscal drag from a reduction in the US budget deficit, the draining of the RRP, rebuilding of the TGA, continuation of QT, and the tightening of financial conditions from corporate tax payments.

It’s critical that the Fed resumes its rate-cutting cycle on September 17.

Notable market movements from interest rate sensitive stocks such as homebuilders and small caps, bond yields, gold, and the US dollar have already raced ahead, pricing in a growing number of Fed rate cuts between now and the end of next year.

As the future path of monetary policy comes into sharper focus, expect bouts of capital market volatility in these assets.