Navigating Fed Rate Cuts: Uncertainty and Sticky Inflation Ahead

Investors appear headed for a volatile few months after the Federal Reserve resumed cutting interest rates and opened the door to further easing, while simultaneously warning about sticky inflation. Some investors are now less certain that a rapid shift to lower borrowing costs will materialize, potentially dampening optimism that stocks and bonds will see a robust boost from looser policies. Adding to the uncertainty is the significant division within the Fed on the future path of interest rates. "We've held a fairly cautious, though not necessarily outright defensive, view for some time, and the Fed's message reinforces that," said Larry Hatheway, global investment strategist at Franklin Templeton Investment Institute. Hatheway added that many in the market may be slightly disappointed by the Fed's lack of clarity and direction, with the central bank not explicitly backing the market's expectations of a clear-cut string of rate cuts, but instead emphasizing a meeting-by-meeting, data-dependent approach. On Thursday, the Fed lowered its policy rate by 25 basis points to a range of 4%-4.25%, its first cut since last December, and signaled a gradual easing cycle in response to growing labor market concerns. At the same time, Fed Chair Jerome Powell highlighted a "challenging situation" facing policymakers, noting that inflation risks are tilted to the upside while employment risks are tilted to the downside. These comments tempered market optimism, although the market had been very hopeful for a dovish pivot from the Fed after recent data showed the unemployment rate climbing to 4.3% in August and job growth coming in well below expectations. A sharp downward revision earlier this month to annual employment data through March also further supported the idea that the labor market is losing momentum, providing a rationale for multiple rate cuts by the Fed going forward. Compared to the dot plot released at the June meeting, the latest dot plot reflects expectations of more easing this year, with projections for an additional 50 basis points of cuts before year-end. Meanwhile, the Fed's forecasts still see inflation at 3% at the end of this year, well above its 2% target, while its forecast for economic growth was revised slightly higher to 1.6%, from 1.4% in June. "Markets may welcome this easing bias, but the message conveyed remains nuanced and far from a complete pivot," said Dan Siluk, global head of short-term and liquidity, and portfolio manager at Janus Henderson Investors. The Nasdaq and S&P 500, which had been near record highs heading into the meeting, wavered and closed lower. U.S. Treasury yields rose, with the two-year yield up 4 basis points on the day at 3.55%, while the benchmark 10-year yield rose about 7 basis points to 4.09%. In recent weeks, the yield curve has been flattening due to rate cut expectations, with the gap between long- and short-term yields narrowing. "The Fed is in a tough spot," said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. "They're forecasting stagflation, which is higher inflation and a weaker labor market. That's not a good environment for financial assets." ### The Specter of Stagflation The U.S. consumer price index (CPI) in August posted its biggest gain in seven months as housing and food costs rose, pushing the annual inflation rate to its highest level since January. Coupled with weakening labor market conditions, higher inflation has stoked fears of stagflation. This is a troubling combination of slow growth and high inflation that plagued the U.S. in the 1970s and could complicate the Fed's ability to support the labor market through aggressive rate cuts. "This is far from the stagflation of the 1970s, but at the margin, it supports taking a more conservative outlook on equity and bond returns," said Michael Rosen, chief investment officer at Angeles Investments. Following the Fed's move to ease policy, the move is also being scrutinized after the Trump administration had put relentless pressure on the Fed to cut rates. Trump nominee and economic advisor, Milan, was sworn in as a member of the Fed's Board of Governors on Tuesday and cast the sole dissenting vote against the Fed's 25-basis-point rate cut decision, instead advocating for a much larger 50-basis-point cut. Markets have also had to contend with the wide array of forecasts shown in the Fed's dot plot, with one participant projecting a year-end rate of 4.4%, above the new 4.00%–4.25% range. On the other end, one policymaker pegged the year-end policy rate at 2.9%. "I think the market is having a hard time digesting all the information they're getting," said Josh Hirt, senior U.S. economist at Vanguard. "Certainly, this doesn't provide anybody a very clear view on how Fed policymakers are approaching decisions." Hirt added, "There's so much disagreement amongst committee members that uncertainty has been heightened, and one potential consequence that derives from that is greater volatility."