Could Inflation Dampen Investors’ Rate-Cut Hopes?

A weak jobs report has markets embracing the need for the Federal Reserve to lower interest rates, but the risk of inflation rearing its head again may dampen some of the enthusiasm.

Lower interest rates would give a needed jolt to a clearly weakening economy, but some analysts warn that they could also overstimulate demand and push up prices. That would come at a time when inflation remains somewhat elevated, and tariffs threaten to raise prices further.

The Fed’s job is to balance interest rates so that the country has maximum employment and stable prices.

Given the “anemic” pace of job growth in August, the Fed will likely cut interest rates and support its maximum employment mandate, Bank of America economist Aditya Bhave wrote on Friday. The jobs report will prompt the Fed to shift “from worrying about inflation to focusing on labor weakness,” he wrote.

That doesn’t mean the Fed can ignore its price stability mandate, however. Inflation “is still problematic” and “will keep the Fed cautious” as it cuts rates, Bhave wrote.

He sees the Fed cutting rates next week and again in December. The Fed’s current policy keeps the benchmark interest rate between 4.25% and 4.50%, and lowering it to a range of 3.75%-4% as Bank of America expects would make borrowing a bit cheaper across the country.

Markets, however, see rates reaching as low as  3.5%-3.75% by year-end.

Upcoming inflation data will be critical in determining whether investors’ hopes for more aggressive rate cuts after September will come to fruition, according to Douglas Porter, chief economist at BMO.

“The market is heavily building in the odds of quick follow-up cuts in October and December,” Porter wrote in a note to clients. “We’re not quite all the way there yet, but are starting to lean in that dovish direction if upcoming inflation reports cooperate.”

August Inflation Data May Be Critical

The next key inflation reading will come on Thursday, when the Bureau of Labor Statistics is scheduled to release the Consumer Price Index for August.

The CPI index will likely show prices rose by 2.9% in August compared to a year earlier, Porter forecasted. While the increase is far milder than the post-COVID high, inflation nonetheless remains above the Fed’s 2% target.

Prices will “ultimately go higher in coming months as the wall of tariffs is gradually more fully passed onto consumers,” Porter wrote.

July’s data showed some early signs that President Donald Trump’s tariffs are pushing up prices, but not by much. Price increases for cars and major appliances have stayed mostly subdued, for example, even as furniture and electronics have gotten more expensive.

Businesses were able to avoid price hikes thanks to the “burst of inventory front-running” from abroad before tariffs kicked in and made some imports more expensive, Wells Fargo senior economist Sarah House wrote in a research note. 

“Yet, as stockpiles have dwindled, merchandise imports have started to rebound with U.S. firms seeing steep increases in customs bills,” House wrote, which companies may pass onto consumers by raising prices.

Could the Fed Take More Aggressive Action?

Some investors believe weak jobs data will outweigh inflation concerns and prompt more aggressive Fed action. The Fed tends to cut rates by just 0.25% at a time, but markets are entertaining the possibility of a half-point cut in September.

That type of move is possible, but not what ING is forecasting, James Knightley, chief international economist at the financial institution, wrote in a research note. The risk of tariff-driven inflation “means there probably won’t be a majority” of Fed voters in favor of a half-point cut in September, he wrote.

Instead, he predicts the Fed will cut by 0.25% in September, October and December, with a couple of more cuts coming in early 2026.

Inflation remains a risk, he wrote, but there is also a “real threat” that job losses may be on their way. He pointed to a University of Michigan consumer survey showing more than 60% of Americans believe the country will see higher unemployment over the next year.

“People see and feel changes in the jobs market before they show up in the official data—they know if their company has a hiring freeze or the odd person here or there is being laid off,” Knightley wrote.

Fed officials may set aside inflation worries to protect against further economic weakness, he argued.

“That justifies the Federal Reserve taking early action even if some members are not fully comfortable with the inflation story,” he wrote.