Fed's Rate Cut Outlook: Balancing Employment vs. Inflation Concerns

The Fed at a Crossroads: Supporting Jobs vs. Curbing Inflation

The Federal Reserve appears ready to cut interest rates again this month, driven by a growing concern over a weakening labor market. However, this delicate balance between supporting economic growth and controlling inflation may not last much longer.

There is a clear division within the Fed, with a significant contingent of policymakers cautioning against rushing into further rate cuts, citing that price levels have exceeded the target for many years and continue to face upward pressure. Even those open to two more rate cuts this year are expressing uncertainty about extending that trajectory further.

Uncertainty Surrounding Future Interest Rate Path

All of this suggests that the path of borrowing costs in the United States by 2026 holds a significant amount of uncertainty, much higher than what financial markets currently anticipate. Economic data itself isn't helping to clarify the picture, as it points to diverging trends: resilience in growth and consumer spending, versus a slowdown in hiring. The government shutdown, which froze the release of some key economic data, further complicates matters. And weekly comments from Fed officials are turning into an increasingly heated debate.

Powell's Employment Warning

The task of unifying these diverging positions falls on Fed Chairman Jerome Powell. He has indicated that there is a risk in delaying action, suggesting that the Fed will cut interest rates at the upcoming Federal Open Market Committee (FOMC) meeting on October 29. Weak employment growth over the past few months, coupled with significant downward revisions to early data, has upended the widespread view of a strong U.S. labor market. Powell describes the current situation as an economy characterized by "low hiring, low firing" with no signs of widespread mass layoffs, warning that this balance could be fragile.

"You’re at a point where further job declines would likely be reflected in the unemployment rate," he said at an economics conference on October 14.

His remarks were seen as solidifying expectations for a 25-basis-point rate cut this month. Traders in the futures markets already anticipate this, and are confident that there will be another cut in December. If they are right, this would align with the median projections presented by Fed officials last month.

Future Challenges

But after that, things could get more complicated, says former St. Louis Fed President James Bullard. He adds: "The October (rate cut) is going to happen. But while the possibility of subsequent cuts remains, the fact that inflation is running high and that growth looks fairly strong, is putting the December cut at risk."

The argument espoused by hawks is strong enough to convince eight of the 19 Fed officials to predict that there will be no further rate cuts next year. Many believe that consumer prices face a constant threat from tariffs, as highlighted again by the latest trade frictions.

"It’s been 54 months since inflation reached or undershot the target," says Tim Mahedy, a former advisor to the San Francisco Fed. "There are undoubtedly risks in the labor market, but there are also inflation risks, especially if the economy continues to maintain its momentum, as evidenced by the government's announcement last week of the possibility of imposing more tariffs."

Within the Fed, Governors Christopher Waller and Michelle Bowman, both considered doves, view employment as the primary concern.

A new voice has emerged in the Fed's internal debates: Neel Kashkari, who has urged a series of rapid 50-basis-point cuts, but he is currently still in the minority.

Leadership Changes

One factor making it more difficult to predict the path of interest rates next year is that the Fed and the U.S. economy will see changes. Powell's term as chairman expires next May. President Trump has stated that he will choose a successor committed to lowering borrowing costs, and that he has sought other ways to push the Fed in that direction. But next year, the presidents of the Cleveland Fed, Loretta Mester, and Dallas Fed, Lorie Logan, both considered hawks who have expressed caution about further interest rate cuts, will replace the outgoing members of the committee.

Stephanie Roth, chief economist at Wolfe Research LLC, believes that the balance between employment and inflation risks will shape the debate over Fed policy in 2026, which may lead to more cautious action than investors currently anticipate.

She says: "The amount of rate cuts that the Fed will ultimately deliver is likely to be less than what the market is pricing in. That may be recognized early next year with the economy running slightly hot."