FOMC Preview: A September Risk Management Cut Comes Into View

Summary

• Employment risks are rising due to weaker growth that itself reflects low private sector confidence and continued extreme policy uncertainty.
• Weak growth is containing US tariffs’ passthrough, but long-term inflation risks are increasing.
• Long-term market-based inflation expectations remain stable while survey-based expectations are falling.
• The real economy and financial markets suggest the Fed’s policy stance is only moderately restrictive.
• With the US economy roughly aligned with the SEP, 2025 cuts are coming into view and Chair Powell could hint at a September cut.

Market Implications

• I still expect two-three 2025 cuts and at most one 2026 cut against markets pricing two and three cuts, respectively.

Labour Market Softer Than Appears

In his most recent economic speech on 1 July, Powell stated, ‘growth and the labour market’ were ‘solid.’ The Fed expected ‘higher inflation readings over the summer’ and was ‘watching carefully for unexpected labour market weakness.’ Powell thought policy was ‘modestly restrictive’ and a ‘solid majority’ of the FOMC ‘expected rate cuts later this year.’

While governors Bowman and Waller have argued for a July cut, most FOMC members support Powell’s decision to remain on hold next week. Also, recent data releases support a September cut.

As Powell stated, the labour market looks solid, with unemployment around 4.1% for the past year or so (Chart 1). Unemployment is stable despite slower NFP growth, to 155k monthly average over the past 12 months from 185k monthly average the year before, indicating slowing labour supply. In turn, this reflects the end of the immigration surge started in 2021 as well as US population aging (Chart 2).

However, signs of demand weaknesses are emerging. Employment growth is increasingly concentrated in a few sectors. In June, state and local governments accounted for about half of the increase and two sectors accounted for all private sector gains (Chart 3).

In addition, despite the low unemployment rate (UR), wage growth has been slowing (Chart 4).

Chart 1: Low UR Despite Slower NFP Growth	Chart 2: Much Lower Immigration
Chart 3: Concentrated NFP Growth	Chart 4: Softer Wage Growth

In turn, the softening labour market reflects slower growth.

Growth Slowdown to Continue

Growth is slowing. Tariff frontrunning has distorted Q1 growth, seeing a spike in imports and a GDP contraction (Chart 5). Q2 followed with a large import decline and a GDP recovery. On average, and based on the Atlanta Fed’s GDP Q2 nowcast, H1 growth is likely below 1% SAAR, compared with 2.9% in H2 2024.

Slower growth largely reflects an increase in precautionary savings given exceptional policy uncertainty and weak consumer and business confidence (Charts 6-8).

Two quantitative indicators signal rising recession risks. The OECD and the Conference Board’s (CB) Leading Economic Indicators (LEIs) show the business cycle has peaked, with the LEI hitting its recession trigger in June (Chart 9). The Richmond Fed’s SoS indicator, an improved version of Sahm’s rule, has been increasing steadily, though it remains well below its recession trigger (Chart 10).

Chart 5: Growth Is Slowing	Chart 6: Higher Household Savings
Chart 7: Still Exceptional Policy Uncertainty	Chart 8: Still Weak Private Confidence
Chart 9: CB LEI Recession Trigger Hit in June!	Chart 10: Jobless Claims Show Rising Risks

Soft demand growth has contained tariffs’ price impact.

Inflation Risks Greater in 2026 Than 2025

Regarding the impact of tariffs on prices, the Fed is concerned about risks of higher long-term inflation rather than by higher prices. The latter is to be expected as passthrough to consumers is unavoidable. The FOMC thinks tariff risks depend on ‘the size of the tariff effects, on how long it takes for them to passthrough fully into prices, and ultimately, on keeping longer-term inflation expectations well anchored.’

In 2025, inflation risks appear limited largely because weak demand is containing businesses’ pricing power. Tariffs have only impacted tariffed goods rather than non-tariffed goods or services and the passthrough has been limited (Charts 11 and 12). Also, the price of discretionary services such as travel, hotels, movie theatres and sports event tickets has been falling, partly offsetting the increase in the price of tariffed goods.

By contrast, risk of inflation acceleration in 2026 exists for four key reasons. First, it is uncertain how long and high the Trump administration will raise tariffs.

Since end-April, the administration has increased tariffs that now near their ‘Liberation Day’ peak, though tariffs are lower due to implementation lags (Chart 13).

In addition, further tariff increases start on 1 August when reciprocal tariffs will hit countries that have not struck a deal with the US. Furthermore, the Department of Commerce has several Section 232 investigations underway that are likely to cause new tariff increases on specific commodities and manufactured goods.

With very large tariff increases, businesses will have to pass on costs to customers or, if they are unable to, close. The administration could miscalculate and impose tariff increases so large the manufacturing sector, and possibly the whole economy, are tipped into recession.

Second, risk exists of fiscal stimulus ahead of the US mid-term elections (Chart 14). The One Big Beautiful Bill Act (OBBB) implies about one ppt GDP increase in the FY2026 budget deficit relative to FY2025, before tariff increases. Higher tariffs would reduce the fiscal impulse but lift business costs. I reckon tariff increases could fund about half of the FY2026 deficit increase, though this is highly uncertain.

Third, with much lower immigration, the economy’s potential growth rate (the speed limit on actual growth) is falling. I expect labour supply growth to slow to about 0.5% in 2026, from about 1% in 2025 (Chart 15). In this context, a policy stimulus could add to inflationary pressures and long-term cost pressures could come to the fore.

Fourth, the US was experiencing long-term costs pressures long before higher tariffs. Goods price inflation has been accelerating for 18 months and has just turned positive following two decades of deflation. This likely reflects factors such as limits to globalisation, slower productivity growth in the semiconductor sector, or climate change (Chart 12). Because these factors are secular, goods price inflation acceleration is likely to continue in 2026.

For instance, food price inflation has been accelerating (Chart 16). While the Fed relies on core PCE as the better indicator of inflation trends, it is targeting headline rather than core inflation (Chart 16). Should the increase in food price persist, headline inflation would move further away from the Fed’s 2% target.

Against these 2026 risks, Powell’s preferred measure of long-term inflation expectations, 5y5y BEs, have remained stable (Chart 17). Survey-based inflation expectations, which had been a concern for FOMC members, have been falling (Chart 18).

Chart 11: Limited Tariff Impact	Chart 12: Inflation Risks Ahead
Chart 13: Risks of More Tariff Hikes	Chart 14: Budget Deficit Higher in 2026?
Chart 15: Slower Employment Growth Ahead	Chart 16: Rising Food Inflation
Chart 17: Stable Long-term BEs	Chart 18: Lower Survey-based Expectations

Overall, inflation risks appear more medium-term than immediate. The Fed must assess its policy stance before deciding its next move.

Policy Rate Near Neutral

Based on the dot plot, the FFR is about 125-150bp above neutral (Chart 19). Yet economic and financial conditions suggest the FFR is nearer neutral.

The FFR is near my core PCE-based Taylor rule (i.e., the FFR aligns with current inflation and unemployment. The Taylor rule computes the policy rate as an average of the deviation of inflation and unemployment from their long-term values, Chart 20).

Also, equity market valuations appear elevated (Chart 21). SPX P/E ratios are near Internet Bubble highs. Shiller’s CAPE, which uses 10-year average inflation-adjusted earnings, are near 2021’s highs.

The Fed’s broader measures of financial conditions show they are currently a tailwind to growth (Chart 22).

Chart 19: Long-term Dot Is Too Low!	Chart 20: FFR Aligns With Taylor Rule
Chart 21: Expensive Stocks!	Chart 22: FCI Adding to Growth!

September Cut Comes Into View

Against these developments, recent Fedspeech has on average been neutral to hawkish (Chart 22). At next week’s meeting, Powell is likely to state the Fed makes decisions meeting by meeting, based on ‘the incoming data, the evolving outlook, and the balance of risks.’

Nevertheless, with recent economic development roughly aligned with the SEP, 2025 cuts are approaching (Table 1). Powell could hint that the Fed may start cutting in September provided inflation remains consistent with FOMC expectations.

The Fed would be cutting despite stronger inflation risks in 2026 for precautionary reasons. It is unclear whether the growth slowdown will be self-correcting as markets expect. Policy uncertainty remains exceptional and the very large tariff increases could yet tip the economy into recession.

In addition, stable long-term inflation expectations would mitigate risks of cutting too soon. These show the Fed has credibility and can afford to cut with limited risks to the long-term inflation trajectory.

Table 1: Economy Roughly Aligned With June SEP (%)

Chart 23: Neutral Fedspeech on Average	Chart 24: Market Pricing Too Many 2026 Cuts

Market Consequences

I still expect two-three 2025 cuts and at most one 2026 cut against markets pricing two and three cuts, respectively (Chart 24).

Table 2: Recent Fedspeak

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