When engaged in the dark arts of foretelling the Fed’s words and actions, I have always adopted what might be called the "prudent economist rule". What would a prudent economist, serving as a Fed banker, do - assuming that they were armed with a reasonable economic forecast and with due consideration for the Fed’s inflation and unemployment goals and the need to maintain financial stability?
This rule breaks down, however, if the Fed banker also considers the strongly-expressed wishes of the administration and the possibility that both their job and Fed independence may depend upon their decision.
Futures markets currently forecast a 25 basis point cut on Wednesday with two further cuts this year and probably another three in 2026. We generally agree with this perspective. However, this doesn’t align with the Fed’s forecast for the economy or its recently stated decision rule on how it would respond if it is simultaneously missing on its inflation and employment goals. This being the case, while markets have preemptively celebrated the restart of the Fed’s cutting cycle this week, its consequences may ultimately be negative for stocks, bonds and the dollar, suggesting investors adopt a more cautious and globally-diversified stance.
Tensions in the Forecast
In Jay Powell’s press conference after both the May and June FOMC meetings, he included the following language:
We may find ourselves in the challenging scenario in which our dual-mandate goals are in tension. If that were to occur, we would consider how far the economy is from each goal and the potentially different time horizons over which those representative gaps would be anticipated to close.
Interestingly, this language was dropped from the July opening statement. This could be because Powell and the FOMC realize that they are about to violate this policy.
The problem should be evident in the Summary of Economic Projections (or SEP) that the Fed will release on Wednesday.
Overall, we don’t expect much change in their GDP forecasts. The June SEP projected year-over-year real GDP growth of 1.4% in 4Q2025, 1.6% in 4Q2026 and 1.8% in 4Q2027 – mediocre numbers to be sure, but not indicating recession. While the labor market is losing momentum, consumer spending on high-end goods and services continues to look solid as does business spending related to AI. Moreover, we expect consumer spending to jump in early 2026 in response to a bumper crop of income tax refunds, before fading later in the year. Overall, it is possible that the committee will nudge down their forecast for this year to 1.3%, but otherwise leave their growth forecasts unchanged.
On the unemployment rate, they might only raise their 4Q2025 forecast slightly, from 4.5% to 4.6%, which would still be close to their 4.2% long-run expectation. This would reflect the fact that, while a slowing economy and uncertainty are reducing payroll job gains, a sharp change in immigration policy is constraining labor supply and thus limiting increases in the unemployment rate. In June, they expected unemployment to stay relatively elevated at 4.5% at the end of 2026 and 4.4% at the end of 2027. Given increasing labor supply constraints and a rebound in consumer spending in early 2026, we don’t expect them to raise their 2026 and 2027 unemployment rate forecasts this week.
Meanwhile, they could raise their estimate of 4Q2025 year-over-year PCE deflator inflation to 3.2% from 3.0%, well above their 2.0% long-run target. This would reflect growing pass-through tariff effects and the reality that the average tariff rate is now 19.2%, compared to 14.6% at their June meeting. Moreover, our own forecasts suggest that year-over-year inflation could continue to rise early in 2026, peaking at 3.7% in 2Q2026, due to some delay in full tariff impacts and the stimulus embedded in a wave of income tax refunds. Consequently, we don’t expect the FOMC to cut their 4Q2026 or 4Q2027 inflation forecasts which currently stand at 2.4% and 2.1% respectively.
Importantly, this means that, by the fourth quarter of this year, inflation could be 1.2 percentage points above the Fed’s target and rising, while unemployment would be just 0.3 percentage points above their target and stable. If this is the outlook, why should the Fed cut at all?
Language, Dots and Consequences
Very likely, the Fed will try to justify a 25-basis point rate cut both in the FOMC statement and in Jay Powell’s press conference. The statement will probably contain a downgrade to language concerning economic growth and note a weakening in labor market conditions. In his press conference, Jay Powell will undoubtedly point to the fact that the committee regards 3.0% as a “neutral” federal funds rate so, even after this week’s rate cut, monetary policy would be mildly restrictive. This is actually a much shakier rationale than it sounds since there really is no way of assessing what the true neutral rate is.
The vote on the rate cut will also be interesting. If FOMC members could truly ignore pressure from both the administration and their colleagues, there would likely be multiple dissents on both sides of this decision. Some members, most notably governors Waller and Bowman, have been vocal in their calls for early easing and might vote for a 50-basis point cut. They could be joined in this by Stephen Miran, the President’s pick to replace governor Adriana Kugler, assuming that he is confirmed by the Senate today. However, we also know that, as of June, seven members of the FOMC felt that no cut was appropriate this year and some of them might vote for no change.
However, Jay Powell is a consensus builder and will likely try very hard to achieve consensus around a slow-and-steady approach to Fed easing. Consequently, this meeting may show some narrowing in the spread around the Fed’s dot plot with a consensus coalescing around two-to-three rate cuts both this year and next.
While markets have generally cheered on the prospect of a first rate cut in nine months, there are three reasons to be cautious.
First, going into this meeting, markets are frothy, with the S&P500 hitting a record high last week and sporting a 22.5 times forward P/E ratio even as 10-year Treasury bond yields have fallen back to just over 4%. Second, as we noted last week, cutting rates at this point is more likely to weaken demand than increase it. And third, to the extent that the Fed’s decision this week is seen as a capitulation to political pressure, a new layer of risk is being added to U.S. financial markets and the dollar. For investors who have benefitted from a roaring bull market over the past three years, this is a good time to consider the need for a more cautious stance and broad diversification into international and alternative assets.