The Fed’s September decision: separating the data from the sideshow

If one were looking to be entertained by high drama during the past month, rather than tuning into the latest Netflix hit, they could, instead, have clicked on a finance website to keep tabs on the build up to this week’s Federal Reserve (Fed) meeting, with its revolving cast of characters and complex plot twists. In the end, however, the market got what it should have expected all along: A garden-variety conclave where evolving data dictated a garden-variety 25 basis point (bps) rate cut, resulting in a 4.00% to 4.25% band for the benchmark overnight lending rate.

Ever since it paused rate cuts after its December 2024 meeting, the Fed’s rhetoric has centered on the tension between the two components of the central bank’s dual mandate: full employment and price stability. Developments over the past several months, including material downward revisions in payrolls growth and tariffs not sending inflation on a higher trajectory (yet), presented the Fed room to modestly ease still restrictive policy.

While lagging employment and inflation data seemed to validate this decision, those looking for palace intrigue may have noticed the curious – perhaps cognitive – dissonance between the decision to cut rates and a more bullish Summary of Economic Projections which called for higher economic growth and inflation in 2026 along with a slightly lower unemployment rate. While Chairman Jay Powell, in the occasional unsteady performance that the market has come to expect, did not provide an elegant argument squaring this, the Fed likely deserves the benefit of a doubt that political influence was not a factor. After all, the possible successors to Mr. Powell on the open market committee were on board with the decision, leaving the recently inserted understudy, Stephen Miran, as the only dissenter as he opted for a 50-bps reduction.

An evolving – but still resilient – economic backdrop

The state of the U.S. economic expansion has come under question in recent months. Perhaps the major culprit was the downward revision of roughly 900,000 payroll gains in the 12 months through March 2025. This sent the period’s monthly average from a healthy 154,000 to a less healthy 80,000. Furthermore, monthly job gains since April have averaged a paltry 53,000. As Chairman Powell rightfully pointed out, however, payrolls are presently being impacted not only by demand factors but also an unprecedented supply shock due to the Trump administration’s forceful immigration policies.

This shift in labor market dynamics has resulted in a unique situation where jobs could be softening at the same time inflation is proving it’s far from vanquished. The Fed’s preferred gauge of core prices – excluding food and energy – rose from 2.6% in April to 2.9% in July. One argument for this week’s cut is that an overnight lending of 4.5% was well above core inflation, denoting restrictive policy. A rejoinder from the relatively quiet hawkish camp could have been that inflation remains far from the Fed’s 2.0% baseline for price stability. Similarly, market-based expectations based on Treasury inflation protected securities (TIPS) predict inflation averaging 2.47% and 2.39% over the next five and 10 years, respectively. Even the Fed raised its own 2026 core inflation estimate from 2.4% to 2.6% despite somewhat dubiously expecting it to recede to 2.0% only two years later.

What’s worth watching

Part of the reason the Fed chose to halt rate cuts last December was anticipation of the incoming Trump administration’s pro-growth – and potentially inflationary – policies. Among these were deregulation, tax reform and, yes, tariffs. Thus far, companies have been able to either absorb or spread out the tariff hit to where imported goods prices have risen less than expected. To be determined is whether the levies result in a one-off resetting of price levels or trade barriers dampen the competition among companies that tends to benefit consumers. What the Fed wants to avoid, perhaps above all else, is expectations for inflation become entrenched well above its 2.0% target.

Unlike 2024 when concerns about slowing growth precipitated 100 bps of rate cuts, with the exception of a clouded labor market, the U.S. economy appears to be on sound footing. Evidence of this is found in a resilient consumer. After its first-quarter hiccup, personal consumption in the second quarter resumed its role in being a key contributor to gross domestic product (GDP). Based on the Atlanta Fed’s GDP Now tracker, this trend has continued deep into the current quarter.

Signals from the corporate sector also hint at a continuation of the U.S. economic expansion. Earnings forecasts that tend to reflect underlying economic strength indicate stable growth over the next two years. Company managers are echoing the market’s view in earnings guidance. The predictive power of earnings should hold special sway in the current environment as companies must account for both the appetite of customers to consume and how tariffs may impact operating margins.

Sourcing the right kind of risk and in the right place

With this meeting, the Fed has charted a path for modestly more dovish policy over the next 15 months – and possibly beyond. Given the central bank’s practice of telegraphing policy so as not to catch the market off guard, much of the appreciation associated with a resumption of rate cuts was already reflected in bond prices. While a welcome development – as long as it doesn’t correspond with a rapidly deteriorating economy – compressed yields do present a challenge for investors. We are nowhere near the reach-for-yield era of the 2010s but low rates and rich corporate bond valuations may compel some investors to either extend duration or increase exposure to lower-quality borrowers to compensate for falling yields. We caution against either of these tactics.

Clearly the pendulum has swung away from price stability and toward full employment. But investors should never lose sight of the deleterious effects that inflation can have on fixed income securities, and with the inflation question far from settled in the U.S. we don’t think extending duration in the country to capture incremental yield is worth the risk.

To compensate for lower U.S. yields, investors concerned about generating attractive income and diversifying against riskier assets should seek to expand their fixed income universe. Five years on from the depths of the pandemic, monetary policies have diverged. This creates opportunities for investors to source duration in markets where rates are still likely to fall and increase exposure to more cyclical corporate credits in regions where the hard work of righting the economic ship has already occurred.

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