Overview
Last week, the Federal Reserve delivered a widely expected 25 basis point rate cut, noting that shift in the balance of risks to its dual mandate of maximum employment and stable prices. In addition, the “dot plot” in the Summary of Economic Projections (SEP) pointed to two additional cuts by the end of the year and one more next year, for a total of 100 bps by the end of 2026, according to the median projection.
In the post FOMC press conference, Chair Powell called the rate cut a “risk management rate cut”, citing the downside risks to the labor market.
“In the near term, risks to inflation are tilted to the upside and risks to employment to the downside—a challenging situation. When our goals are in tension like this, our framework calls for us to balance both sides of our dual mandate. With downside risks to employment having increased, the balance of risks has shifted. Accordingly, we judged it appropriate at this meeting to take another step toward a more neutral policy stance.”
– Chairman Powell, September 17th, 2025
Zooming out just a little bit, in the last few months, markets had widely priced in a more dovish US central bank, as various data releases pointed to increased softness in the labor market – notably, the August employment report showed July, payrolls grew just 22K versus expectations of 75K, the unemployment rate ticked up to 4.3%, and that the US economy created nearly 1 million fewer jobs in the 12 months through March than previously estimated.
However, with inflation still well above the Fed’s 2 percent target, and the disinflationary process appearing to stall, risks are likely to be more two sided. There is a very real possibility that growth may accelerate in coming quarters, while upward pressures on prices from tariffs may still be working their way through the system. Notably, along with the easing in monetary policy, we have seen a broad-based easing in financial conditions and risk-on, or even “fear of missing out (FOMO)-like” market action, in recent months, which has persisted after last Wednesday’s FOMC meeting. Credit spreads have continued to contract, global equities are up, and volatile speculative meme stocks have staged a 50 percent rally year-to-date. Priced-in volatility is low and back at levels we saw in January.
This significant easing in financial conditions will act as a support to demand and US growth. This in turn may exacerbate inflation pressures, at a time when inflation is already running above target. In the first half of the year, economic growth has averaged around 1.4 percent as relatively high rates have frozen up more credit-sensitive areas of the economy, such as housing, with some of the drag from tariffs likely still ahead of us (as businesses pass more costs on to consumers). But between the easing in financial conditions, fiscal support from the OBBBA’s tax cuts (albeit the OBBBA’s impact is only a support to higher income households), and strong non-cyclical pressures for businesses to continue ramping up investment (to avoid missing the AI boat), the balance of pressures on aggregate US growth may be to the upside (current estimates for Q3 GDP growth are north of 3% according to the Atlanta Fed’s Nowcast).
Importantly, any acceleration in US growth could disrupt the delicate equilibrium keeping prices in check. With labor supply also contracting (due to immigration policy changes) and tariff impacts still being passed through, risks to the inflation outlook are on the upside — a scenario that appear to be underpriced by markets. Reigniting inflation would pose material knock-on risks across financial markets, including likely further exacerbating global government debt sustainability issues in the event of a sharp rise in long-term rates, potentially increasing investor concerns regarding the dollar’s status as a reliable storehold of wealth and possibly challenging US equity exceptionalism.
From a financial stability perspective, there is a risk of a “melt up” in financial markets in coming months. With lax financial conditions and asset prices showing signs of froth, investors may be incentivized to take on more debt to boost expected returns from investment (see here for more on the risks associated with a buildup of financial leverage). A notable increase in the use of financial leverage would be particularly pernicious at this late stage of a long financial cycle. Retail participation in financial markets has been growing amid gamification of trading, coinciding with a boom in speculative cryptocurrency trading. Market enthusiasm has been fueled by expectations of financial deregulation by the Administration, further contributing to robust risk appetite, at a time when tighter supervision and regulation may be warranted.
The first two charts below highlight the easing in monetary policy that has been priced over recent months. The two-year nominal yield is down ~40 basis points since July 31st (since our last Roundup report) and the priced in Fed funds rate in 2027 is now ~25 bps below where it was priced to be just three months prior. The second set of three charts highlights the rally in risk assets.
Expectations for a More Dovish Fed Reflected in Rates Pricing
More Dovish Policy are Feeding through with a risk of a “Melt-up” in Markets
The Fed’s Dilemma
Before going into more detail on the risks associated with reaccelerating inflation and on US economic conditions, it’s worth highlighting how the dilemma facing the Fed, especially in light of the ongoing threats to Fed independence, increases the possibility of a policy stance that tolerates higher inflation (and risks a more material inflation acceleration).
The Fed’s Summary of Economic Projections (SEP) suggest that FOMC participants (as proxied by the median FOMC member) judged a lower funds rate path would be needed in order to support growth and keep the unemployment rate low over the forecast period. However, the projected path for inflation was revised up, with inflation not expected to hit the inflation target for another two years . In other words, the Federal Reserve appear to be willing to tolerate higher inflation for longer in order to support growth and employment.
Looking beyond the median, it is worth noting that there was significant dispersion in the FOMC’s forward projections, particularly on the optimal forward path of policy. For example, for 2025, the rage of FOMC participants’ assessment of appropriate monetary policy ranged between 4.38 percent and 2.88 percent, with 6 policymakers seeing no further cuts in 2025. Similarly, for 2026, policymakers outlook for the end of year target level federal funds rate to be between 3.88 percent and 2.63 percent, indicating no real consensus on the outlook or on how to navigate these conflicting pressures.
Coming off a post-COVID period of elevated inflation, resurgent inflation would have material knock-on consequences for a variety of financial markets, namely:
- exacerbated global debt sustainability issues in the event rising inflation puts further pressure on long-term interest rates,
- increased investor worries about the dollar as a reliable storehold of wealth, and
- potentially knock-on impacts for US equities (where significant optimism and exceptionalism are already priced in) and other risk asset prices.
Global Debt Sustainability
Government debt levels have been rising sharply since the pandemic across most developed economies in an environment of elevated inflation and rising long-term rates. This year, yield curves have continued to steepen across much of the developed world, as central banks have taken steps to shrink their balance sheets, leaving price-sensitive investors to step in as the marginal buyers. Inaction to address a deterioration in the fiscal outlook or an inflation shock could lead to a sudden spike in government yields, further increasing challenges for fiscal policymakers. In the US, where the fiscal deficit remains south of -6 percent of GDP, the situation would be exacerbated if the Supreme Court upheld an Appeals Court ruling that President Trump’s reciprocal tariffs were unlawful—such a ruling would slash a key source of revenue for the US federal government and potentially resulting in the US federal government having to return revenues it collected from tariffs throughout this year.
The Weakening Dollar
Continued threats to the Fed’s independence and the perception that it is no longer fully committed to its price stability mandate would have significant implications for investors. So far, survey- and market-based measures of longer-run inflation expectations have remained stable at levels consistent with the Fed’s 2% inflation objective despite some worrying increases at shorter maturities.
That said, market participants have focused on rally in gold that has played out in the last 3 months (with gold’s rally also notably continuing after last week’s FOMC meeting). Of course, to a degree, the gold rally is typical given the decline in US rates over the same period, but the degree has been notable. Gold is an asset with no counterparty risk, with finite quantities available, and with a long history as a reliable storehold of value, so when monetary institutions come under threat and the stability of monetary systems comes into question, spot prices of gold tends to reflect market fears of currency debasement.
It’s also notable we have recently seen the gold rally broaden out from occurring mainly during periods where New York markets are closed (as was the case in 2024) to now rallying during periods when Western markets are open (as shown on the second chart below). This suggests that the recent strength in gold has coincided with a pickup in purchases by Western investors, contrary to previous episodes when demand was driven primarily by Asian investors.
That said, market participants have focused on rally in gold that has played out in the last 3 months (with gold’s rally also notably continuing after last week’s FOMC meeting). Of course, to a degree, the gold rally is typical given the decline in US rates over the same period, but the degree has been notable. Gold is an asset with no counterparty risk, with finite quantities available, and with a long history as a reliable storehold of value, so when monetary institutions come under threat and the stability of monetary systems comes into question, spot prices of gold tends to reflect market fears of currency debasement.
It’s also notable we have recently seen the gold rally broaden out from occurring mainly during periods where New York markets are closed (as was the case in 2024) to now rallying during periods when Western markets are open (as shown on the second chart below). This suggests that the recent strength in gold has coincided with a pickup in purchases by Western investors, contrary to previous episodes when demand was driven primarily by Asian investors.
In recent months the US dollar has been trading largely flat, after a notable sell-off earlier this year. However, taking a longer view, the sell-off so far this year has been relatively small compared to the gains experienced during the bull market period since early in the 2010s (up more than 30 percent versus a trade-weighted basket of currencies). With foreigners holding a significant share of US financial assets, the dollar weakness we saw earlier this year could run much further in the event of a more structural loss of confidence in the dollar and US financial assets as quality storehold of wealth. Anecdotally, there is some evidence that while foreign investors have continued to buy US financial assets (especially equities) in recent months, this was accompanied by a notable pickup in FX hedging ratios (i.e., “buy American assets but hedge the dollar”)–a development that would help the relative weakness of the dollar despite reported inflows into US equities.
US Equity Exceptionalism
US equity markets currently look to be compensating investors relatively little for taking on equity risk. As the chart below shows, even absent the exceptional magnificent 7, US companies trade at a premium relative to international peers. In other words, relative optimism is not just priced in to a small group of US stocks, but is relatively broad-based across the US market (returns on the Russel 2000 year-to-date are now just 3 percent behind year-to-date returns on the S&P 500, with small caps also benefitting from the expectations for easier monetary policy and rising economic optimism).
Of course, starting high valuation levels do not necessarily mean US equities cannot continue to deliver positive returns or that they will not outperform international peers – however, there are greater risks that returns could disappoint in the medium-term when so much optimism is priced at the same time of huge policy and economic uncertainty. Historically, frothy valuations have been followed by periods of low real returns, especially when inflation was high and growth slowed. A significant reassessment of equity risk would have widespread implications, given the record high share of household financial wealth accounted for by equities and the meaningful fraction of US equities held by foreign investors in their portfolios.
While elevated equity valuations make US equities notably vulnerable, other developed equity markets face their own risks. For example, the Bank of Japan announced this month that they would begin selling down their portfolio of Japanese ETFs and JREITs, a negative pressure for Japanese stocks via increased sell flows. While this particular move will admittedly have a limited market impact (as the pace of announced sales is very modest – BoJ Governor Ueda said it would take more than 100 years to completely unwind the BoJ’s ETF portfolio), the signaling impacts are important – the move is the latest to close the BoJ’s chapter on massive unconventional monetary stimulus. More broadly, the BoJ’s massive monetary stimulus over the last decade had bullish knock-on impacts for global assets (as the BoJ’s liquidity found its way out of Japan and into financial assets globally), and the unwind also poses risks well beyond Japanese financial markets.
This next table provides a summary of major market moves over recent key time windows. Key themes are annotated on the table.
Special Feature Topic:
Federal Reserve Independence: Recent Developments
By Jim Clouse
Threats to Federal Reserve independence have intensified dramatically over recent months. Through the first half of the year, the President and the Administration lobbied loudly for much lower interest rates, sharply criticizing Chair Powell in the process and threatening to remove him from office on multiple occasions. The Federal Reserve Act allows the President to remove the Chair or other members of the Board of Governors but only “for cause.” Under long standing legal precedents, the “for cause” requirement has been interpreted to refer to some malfeasance while in office. Most observers judged that the case to remove Chair Powell or any other Board member “for cause” when the “cause” reflected only policy differences would not stand up in court. The Administration has nonetheless ramped up its efforts to change the leadership of the Federal Reserve.In August, Governor Kugler abruptly resigned from the Board, opening a spot for the Administration to nominate Stephen Miran—the Chair of the President’s Council of Economic Advisers—to the position.
Continuing an unprecedented display of partisanship, the Director of the Federal Housing Finance Agency used his office to access confidential records to uncover what he alleged was evidence of mortgage fraud by Federal Reserve Governor, Lisa Cook, in 2021—long before she was in office. The matter was referred to the Department of Justice for criminal investigation. Governor Cook denied the allegations. On August 25, President Trump posted a letter to Governor Cook indicating that he had removed her from office “for cause” based on the alleged mortgage fraud. Governor Cook, filed a lawsuit in opposition to the action and the courts have allowed Governor Cook to remain in office until the legal case is settled. Last week, however, the Administration appealed to the Supreme Court to allow the President to remove Governor Cook while the case is pending.
The Supreme Court’s decision in this matter could have far reaching implications for Federal Reserve independence. The removal of Governor Cook from office would open an additional slot on the Board and increase the number of Governors appointed by President Trump to four—a majority. That majority could make it easier for the Administration to influence the stance of monetary policy. On that score, it’s notable that Governor Miran—attending his first FOMC meeting last week beginning on the same day he was confirmed by the Senate—argued that the FOMC should cut the target range for the federal funds rate by 50 basis points and dissented from the FOMC’s decision to cut rates by only 25 basis points. More generally, many observers have suggested that a Board with a majority of governors appointed by President Trump could be in a position to influence other key aspects of the Federal Reserve System including the leadership of Federal Reserve Banks.
