Political and market pressure is mounting on the Fed to cut the federal funds rate, potentially by a significant margin. The Fed's newly released minutes indicate that FOMC members view inflation as a greater risk than labor market weakness, a stance that pushed tech stocks lower for three consecutive trading days. Investors will look for further clues in Powell’s Jackson Hole speech tomorrow. This piece outlines what the Fed is facing and the most likely path it will take.
Key Challenges
Counterproductive Political Pressure
Outside pressure may actually make a rate cut more difficult, as the Fed is well aware that financial markets care about Fed independence as much as the Fed itself does.
Tariff Impact Waiting Game
Tariff-induced inflation has not yet appeared in the CPI but is beginning to show up in the PPI.
Goldman Sachs estimates that the impact of tariffs on core PCE was 0.2% in the first half of the year and is expected to rise to 0.66% over the remainder of 2025. U.S. consumers will also face an increasing burden from a higher tariff pass-through rate.
Unreliable Labor Data
Payroll data has constantly been revised downward in recent years, even more so in 2025.
More Reasons NOT to Cut Than to Cut
From a purely data-driven perspective, there's really not a strong case for rate cuts, particularly large cuts. Let’s examine the most frequently cited arguments on both sides.
"Preemptive cuts to support growth and avert recession"
Following the 2008 financial crisis, there has been a noticeable shift in how central banks and governments approach economic downturns, employing more aggressive and premeditated strategies to mitigate the likelihood, severity and duration of recession.
While these monetary and fiscal measures helped sustain the economy over the past five years—despite the adverse impacts of a global pandemic, higher inflation, and rising interest rates—the Fed supports growth indirectly through its dual mandate, rather than boosting it directly, especially outside of a recession. A newly developed measure by the San Francisco Fed, using the labor market as a barometer of overall economic health, finds that the odds of a recession currently stand at just 5%.
"Preemptive cuts to boost the labor market"
The unemployment rate is currently 4.2%, well below its historical average and most levels over the past 25 years. Although the employment trend is indeed slowing, the slowdown is not yet sufficient to justify aggressive rate cuts.
The market has grown accustomed to monthly payroll growth of around 200,000, but this expectation could use some updates. With demographic changes (an aging population, low birth rates, and shifts in immigration) and disruptions from AI, full employment may be consistent with just 80,000 new jobs per month, while the economy continues to perform well.
"Rate cuts will reduce the U.S. government's interest payment burden"
While this is a true statement, the Fed’s dual mandate focuses on maximum employment and stable prices, and its role as a banking regulator is to ensure financial stability. Reducing fiscal spending or government interest payment burden is not a priority for the Fed.
Progress in inflation has stalled
The FOMC members' concerns are valid. At this moment, the risks of high inflation outweigh the risks of straining the labor market. Core PCE has come a long way from its peak of 5.65% in February 2022, but has remained in a narrow range of 2.6% - 3% for nearly eighteen months.
The Taylor Rule says we are in the clear
The Taylor Rule, introduced by John Taylor in 1993, provides a prescription for the federal funds rate based on inflation and economic conditions, measured by the output gap or unemployment gap. Using different parameter estimates, the Taylor Rule currently calls for the federal funds rate to be in the range of 4.1% to 5.5% for 2025Q3 - exactly where it stands today.
What Would the Fed Actually Do?
Powell’s Fed is one that rarely surprises the market when rate movements are already priced in. So, even without a strong case for a cut, the Fed will likely lower the federal funds rate in September, citing downside risks to the labor market and the one-time price effects of tariffs on inflation. At Jackson Hole tomorrow, Fed Chair Powell will likely signal that ‘no further cuts’ are guaranteed.
Summary
The Fed does not need to cut rates, but it will do so regardless. A few modest reductions in the coming months would be consistent with the current macro backdrop. What if the Fed cuts more aggressively? It could boost risk assets and economic growth, potentially at the expense of persistent inflation.