With Sticky Inflation, Markets May be Mispricing the Fed

Summary

• We expect a slower, shallower Fed cutting path than markets discount in 2026; sticky core inflation and firmer growth argue for patience.
  
  
• Market pricing may reflect an expectation that the Fed will turn more dovish once a new Chairman is in place next spring. We expect any such shift in the Fed’s reaction function to be modest, though we remain attuned to risks posed by political pressure on the central bank.

The July payrolls report marked an important inflection point for market pricing of the policy rate path. That report, which included significant downward revisions to the prior two months’ payrolls estimates, crystalized investor concerns over labor market weakness and risks to the economic outlook. Early September saw additional downbeat labor data, in the form of a weak August payrolls print and a 911,000 downward revision to the level of payrolls as of last March, as part of the Bureau of Labor Statistics’ annual benchmark revisions process.

In the wake of these developments, the rates market has discounted a policy rate below three percent by the end of next year, with much of the easing front-loaded over the next several FOMC meetings. For example, at time of writing, amidst a government shutdown and renewed tariff threats against China, money markets are pricing in a policy rate of 3.40 following the March 2026 meeting. In contrast, in the Summary of Economic Projections released after the September meeting, the median FOMC participant projected a 3.40 percent policy rate at the end of next year.
 

Source: Bloomberg, Federal Reserve. Market Pricing based on overnight index swap rates and fed funds futures as of October 10.

We remain skeptical that the policy rate will follow the current market-discounted path of policy easing through end-2026, for several reasons. First, payrolls provide an incomplete and potentially misleading picture of current economic activity. Looking more broadly, after a strong second quarter, third quarter GDP is tracking above three percent, reflecting solid economic activity underpinned by strong household spending and the AI investment boom. In addition, payrolls are at best a coincident indicator, and weak readings likely reflect the springtime confidence shock amid the tariff rollout rather than an ongoing collapse in labor demand. Finally, weak labor supply resulting from border and deportation policies have contributed to the slowdown in payrolls growth. There are simply fewer workers to fill open positions in sectors that have historically relied on unauthorized immigrants. The Federal Reserve Bank of Dallas, for example, now estimates that the rate of monthly payrolls growth needed to keep the unemployment rate from rising has fallen to approximately 30,000, from 100,000 at the end of last year.¹

A Very Weak Year for Labor Supply Growth

Source: Bureau of Labor Statistics. 2025 data through August.

Inflation trends also do not suggest that a steady diet of rate cuts over the next year is warranted. The recent increase in core inflation has largely been due to tariffs. But stepping back, progress towards the Federal Reserve’s two percent inflation objective has stalled out over the past eighteen months, with core PCE inflation bouncing between 2.5 and 3.0 percent. Trimmed mean inflation, which removes outlying price movements and is a better indicator of underlying inflation trends than the traditional core reading, has also shown no progress back to the two percent objective. And with sticky inflation in recent years, survey-based measures of inflation expectations are already on the high side and risk de-anchoring from the two percent objective if the Fed quickly cuts rates towards a neutral setting. Higher inflation expectations would make returning inflation to two percent even more challenging in the years ahead.

Inflation Has Been Stuck Above 2.5 Percent

Source: Bureau of Labor Statistics, Federal Reserve Bank of Dallas. Data through August 2025.

Finally, the growth outlook does not warrant a quick return of policy rates to the FOMC’s estimate of neutral. We expect that economic growth will pick up next year, as fiscal policy becomes a stronger tailwind. The gradual adjustment to tariffs, an AI investment boom that has yet to peak, and easy financial conditions are also supportive of stronger economic activity.

This leaves the question of why markets are discounting a steeper rate-cutting path than the Committee itself anticipates. One possibility is that market pricing reflects an asymmetric risk outlook – investors may by and large forecast a decent growth picture but may be more concerned about a growth slowdown than a reacceleration. Payrolls data are certainly consistent with this possibility, but as noted, other activity indicators have been on the firm side.

Another possibility is that market pricing reflects expectations for a dovish shift in monetary policy given the leadership change at the Federal Reserve next spring. This strikes us as a more plausible reading of market pricing, though absent more comprehensive turnover on the FOMC, any shift in the reaction function is likely to be modest. The annual rotation of voting Reserve Bank Presidents also does not suggest a dovish shift in policy.

Still, given pressure from the administration on the Fed, we remain attuned to risks that policy decisions could be influenced by politics, especially if early retirements open up additional seats on the Board of Governors or at Reserve Banks. In this event, we would expect a further steepening of the Treasury curve due to a higher inflation risk premium.

Global Developed Markets Policy

The US monetary policy outlook stands in some contrast with other major developed economies. In the euro area, the European Central Bank has cut rates by over two percentage points since the spring of 2024. With the main refinancing rate now at 2.15 percent, a roughly neutral setting, policy is well-positioned to respond to inflation surprises on either side of the two percent target. Weakness in the industrial sector and disinflationary pressure suggest scope for cuts, but ECB officials remain cognizant of a loosening German fiscal profile. Balancing these factors, we see scope for an additional rate cut before year-end.

While inflation is just modestly above target in the euro-area, it has proven to be stickier in the United Kingdom, with core CPI on a gradual upward trend over the past year and currently running at a 3.6 percent pace. At the same time, the labor market has been weakening, with falling job openings and slowing wage growth. Given these conflicting signals for monetary policy, the Monetary Policy Committee has recently been divided on the rate outlook. Still, we expect the disinflationary read-through from softer activity data to open the door for an additional rate cut by year-end, and potentially an additional cut in the first quarter of 2026.

The Bank of Japan finds itself in a somewhat unique position, being the only advanced economy central bank to raise rates this year. The BoJ has proceeded extremely gradually as it attempts to put zero interest rate policy firmly in the past; indeed, the policy rate sits at just 50 basis points. While investors had largely expected the BoJ to raise rates at its late-October meeting, the elevation of Sanae Takaichi to leadership of the ruling Liberal Democratic Party suggests a more pro-stimulative economic policy thrust, clouding the outlook for monetary policy.  We still see a rate increase this year, but expect it will be delayed until the December meeting.