Inflation’s running quite hot, but I believe the Federal Reserve (Fed) is going to cut interest rates next week for two reasons: 1) the labor market is weak; 2) they’ll argue that hot inflation is transitory.
The Consumer Price Index (CPI) for August showed that inflation is running hot. Headline CPI rose at an annualized pace of 4.7% in August on the back of hotter food and energy inflation. As inflation remains well above the Fed’s target of 2% and crucially is moving in the wrong direction.
Blame Tariffs –
The most obvious source of heat is tariffs, and it’s showing up where you would expect it to— in durable goods.
But tariff-related inflation is not the only source of inflation heat.
A Weak Labor Market –
August payrolls were weak, especially with revisions and a higher unemployment rate, and that pushed investors to price in a 100% probability of a rate cut at the Fed’s meeting next week.
Markets currently expect the Fed to start a series of rate cuts beginning in September, taking the Fed policy rate from 4.4% to below 3% by the end of 2026. And investors don’t expect rates to go back up until at least 2028, and only gradually. In other words, markets expect the Fed to cut rates quite rapidly over the next year or so. But this is where there may be a disconnect between what the market expects and Fed members. Given inflation heat, the Fed may not be ready to commit to a series of rate cuts beyond a couple of more this year, at least not as much as the market expects.
Nevertheless, the big picture is that I think the Fed is going to start cutting rates once again after a nine-month pause, even as inflation remains elevated (and going in the wrong direction). That is bullish for the market. It means the Fed’s priority is to protect the labor market (and the economy) even at the risk of running things hot. There’s a reason why stocks continue to rally and make one new all-time high after another, and the profit outlook really hasn’t dimmed.
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