Ivanna Hampton: A change in priorities prompted the Federal Reserve to cut interest rates for the first time in 2025. Fed Chair Jerome Powell says a softening job market is carrying more risk than stubborn inflation. The Fed trimmed a quarter percentage point as expected and signaled more cuts are on their way. Joining me to discuss these developments is Preston Caldwell. He is a senior US economist for Morningstar Investment Management. Thank you for being here, Preston.
Preston Caldwell: Hey, Ivanna. Thanks for having me.
Hampton: Now, the Fed chair described the job market as solid just a few months ago, but that description has changed. Can you talk about the tough role the Fed is in with balancing the weakening job market while inflation remains above its 2% target?
Caldwell: In the last several months, we’ve gotten in new data, which shows the labor market to be in probably much weaker conditions, although the conditions are very unusual, too. And so over the last few months, in terms of the jobs reports, and then especially earlier this month, when we got the BLS’ preliminary benchmark revision, altogether, that’s showing that by our estimates, employment growth in terms of nonfarm payrolls stood at about 0.5% year over year as of August. Previously, that was reading about 1.0% year over year. So, 0.5% year over year, that’s considerably weaker than normal, which would be about 1.0% to 1.5%. We averaged about 1.5% in the three years before the pandemic, for example.
Nevertheless, we haven’t seen really much of a rise in unemployment yet. It’s averaged 4.2% in the past three months compared to 4.1% in the first quarter of this year, probably because labor supply has fallen at the same time that labor demand has fallen, perhaps because of or almost certainly because of reduced immigration. But the risk that, as Powell points out, is that if labor demand continues to fall, at some point we could see this rise in unemployment start to set in and potentially tip the economy over into this vicious cycle of layoffs and economic contraction, which, once that is set in motion, it’s very hard for the Fed to undo it. So, the Fed wants to avoid that. And so the balance of risks, even with inflation heading back up again a little bit, that balance of risks calls for looser monetary policy and rate cuts.
Hampton: The Fed released its dot plot, which shows expectations for interest rate cuts between 2025 and 2027. Talk about what was significant about these projections and how they line up with your own.
Caldwell: The Fed is expecting two more rate cuts, one rate cut each, in its two final meetings this year, which would take the federal-funds rate down to 3.50% to 3.75% at the end of this year, which is in line with current market expectations, in line with our expectations. And then the Fed only has one rate cut penciled in for 2026. The market’s expecting three rate cuts, and we’re right in between. We think there’ll be two rate cuts, so not really a huge divergence between the three sets of expectations there, but I think the Fed, they sometimes are a little bit inertial in terms of their forecast revisions, so I wouldn’t be surprised if the next set of projections is a little bit lower for the end of 2026, and so not a huge divergence right there.
I think our expectations and the markets, as well as the Fed, are that the federal-funds rate is going to move a lot lower, again, reaching 3.00% to 3.25% by the end of 2026. And at this point, I think that’s needed to keep the longer end of the curve where it’s at right now. The 10-year Treasury yield dropped from several months ago—4.4%, 4.5%. Now it’s at barely over 4.00%, and that’s starting to feed through into lower mortgage rates, which really is needed to shore up the housing market quite desperately right now, in addition to other interest-rate-sensitive parts of the economy.
Hampton: What risk, if any, could tilt the scales and force the Fed to resume its fight against inflation?
Caldwell: Well, I think most assume that the inflationary shock from tariffs will be more of a one-off event. And so we expect inflation to peak in 2026, but then start to fall quickly. And also that there will be downward pressure on inflation from the slack in the economy and labor markets that will start to weigh in the latter half of 2026 on inflation and going into ’27 and ’28. So, if instead inflation is more unanchored, as we say, from the Fed’s 2% target, such that it builds up momentum.
And when you have this one-time shock to inflation from something like tariffs, that actually just continues period after period. And so maybe inflation stays closer to 3% in 2027. And also, you have perhaps upward pressure from an overheating economy if the hype around AI starts to drive up business investment more uniformly, and perhaps high asset prices also lead to booming consumer expenditure, all of those forces could keep the economy somewhat hotter and keep inflation higher and call for at least a suspension of any further rate cuts. But that could call for the federal-funds rate—let’s say it gets to 3.5% at the end of this year, it could call for it to go back up to 4.0% or something. We can’t rule that out right now. It’s a credible scenario, but you’ve also got a scenario where we have a recession and rates go much closer to zero.
Hampton: Well, Preston, that gives us a lot to consider. Thank you for your insights and time today.
Caldwell: Good to talk with you, Ivanna. Thank you.
