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The Fed’s 25 bps cut—its first in nine months—marks a pivot amid deteriorating labor market data and persistent inflation overshoot above the target. Powell’s messaging and the SEP reveal a growing bias toward risk management, with a narrow majority signaling two more cuts in 2025 (our view: only one more cut in 2025). The removal of “solid” from labor market language underscores rising concern over cyclical fragility. While inflation remains sticky, the Fed appears willing to tolerate modest overshoots to preserve employment stability. Still, market pricing of rate cuts in 2026 seems highly improbable.
Fed cut rates by 25bps: members divided on the extent of further rate cuts
The Fed cut policy rate by 25 bps in line with recent expectations (a delay we anticipated since May: Stagflation fears induce FED paralysis? and our warning in Jul Keeping options open may come at a cost). In the latest summary of economic projections (SEP), the dot plot median showed three rate cuts in 2025 in line with market pricing. However, markets are pricing two additional rate cuts by end-CY26 vs. the FOMC median.
Greater weight to labor markets deterioration despite growth upgrades
We argued post May FOMC that the downside risks to growth must dominate policy focus but stagflation fears have likely induced paralysis and heightened the risk of policy errors. Despite 20 bps growth upgrades, growth remains weak and a faster convergence to terminal rate (r-star) alleviates some of the downside risks.
2026 core inflation projections revised higher (+20bps): caution warranted
The core PCE inflation projection remained unchanged for CY25. However, price pressures in 2026 are expected to remain higher than the previous projection (2.6% YoY vs. 2.4% earlier). While long-term inflation expectations remain stable and tariffs must be treated as a one-period shock, the Fed is right to remain cautious about how quickly it eases policy in such an environment. Optimistic market pricing w.r.t rate cuts likely assumes that the Trump appointees will deliver more/faster cuts than optimal under the current scenario.
1pp rate cut priced in; UST 10Y yields below 4% unlikely to sustain for very long
We are now in the era of higher-for-longer rates (Sep-23 report). Higher reliance on T-bills (post Mar-25) to finance deficits have kept UST rates under check: share of incremental issuances over 3M via T-Bills was -10% in Mar-25 but rose to 45% in Aug-25. Lower rates on 10Y bonds make long duration borrowing more attractive thus putting upward pressure. Hence, UST rates are unlikely to remain below 4% on a sustainable basis despite rate cuts.
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