By: Brent Schutte, CFA
Stocks registered mixed performance last week as stronger than expected economic data, including an upward revision to second-quarter gross domestic product (GDP) growth to 3.8 percent, led some investors to fear that the Federal Reserve would be less aggressive with future interest rate cuts. As a fresh batch of inflation data brought few surprises, emboldened traders bought the dip as the Federal Reserve turned its gaze to a cooling job market.
The pace of core inflation remained little changed in August, according to a report from the Bureau of Economic Analysis (BEA) on Friday, showing that the Fed’s closely watched the core personal consumption expenditures (PCE) price index—which excludes more volatile food and energy costs—rose 0.23 percent in August compared to 0.24 percent in July.
We have consistently stated that the last leg of taming inflation will be the most difficult. Core PCE inflation has been stuck in a narrow range of 2.6–3.2 percent year over year since the end of 2023, with the current reading of 2.9 percent representing the highest rate since February. While that figure remains well above the Fed’s 2 percent target, it is also widely in line with recent economic forecasts—leaving many investors convinced that the Fed remains on track to further reduce interest rates. Federal funds futures are pricing in a nearly 90 percent possibility of an additional quarter-percent rate cut at the U.S. central bank’s October meeting and around a 73 percent probability of a third cut in December.
However, we continue to believe that the full economic impacts of tariffs have yet to materialize in the supply chain and caution against penciling in a certainty of future rate cuts. Federal Reserve Chair Jerome Powell warned the Greater Providence Chamber of Commerce in Rhode Island on Tuesday. A “reasonable base case” would be that the tariff-related effects on inflation will be relatively short-lived in the form of a one-time shift in the price level. But “a ‘one-time’ increase does not mean ‘all at once,’” he reminded the audience. “But uncertainty around the path of inflation remains high. We will carefully assess and manage the risk of higher and more persistent inflation. We will make sure that this one-time increase in prices does not become an ongoing inflation problem.”
While inflation remains above the Fed’s 2 percent target, the Fed’s focus is shifting to the labor market given its recent weakness. “You’ve got a low firing, low hiring environment. And the concern is that if you start to see layoffs, the people who are laid off—there won’t be a lot of hiring going on. So that could very quickly flow into higher unemployment,” Powell stated after the Fed’s September 17 meeting, when the U.S. central bank opted to cut its benchmark interest rate by a quarter-percentage point.
Initial jobless claims fell to a seasonally adjusted figure of 218,000 for the week ending September 20, according to the U.S. Department of Labor, a 14,000 drop from the previous week’s revised level. While the previous week’s numbers were revised slightly upward, the overall trend of decreasing claims is consistent, reflecting a “low firing” environment in which employers may lay off their existing workforce. The four-week moving average was 237,500, representing a 2,750 decrease from the previous week’s revised average in another sign of a stagnant employment situation.
On the other side of the coin nonfarm payrolls have averaged a low 27,000 jobs per month over the past four months, indicating a “low hiring” scenario in which much of those hires are occurring in the more noncyclical health care and social assistance industries. Furthermore, the nonfarm payrolls one-month diffusion index has hovered below 50 percent for four consecutive months, suggesting a further softening in the labor market. This has set up what Powell has previously called “a curious kind of balance” in which the demand for and supply of workers have declined simultaneously.
“In this less dynamic and somewhat softer labor market, the downside risks to employment have risen,” the central bank chair noted on Tuesday. “Near-term risks to inflation are tilted to the upside and risks to employment to the downside. … If we ease too aggressively, we could leave the inflation job unfinished and need to reverse course later to fully restore 2 percent inflation. If we maintain restrictive policy too long, the labor market could soften unnecessarily.”
These risks have already begun to show up in the data. U.S. consumer sentiment dropped to a four-month low of 55.1 in September, according to data from the University of Michigan on Friday, down from a preliminary reading of 55.4 earlier this month and 58.2 in August. The drop-off reflects concerns over both rising inflation and a softening labor market as consumers absorb mixed messages about the economy. Sixty-five percent of respondents expected more unemployment in the coming months; a historical reading resembling levels observed only during periods of economic contraction. At the same time, consumers expect five- to 10-year inflation to come in at 3.7 percent, the highest inflation expectations observed since June of 1993 (excluding the period between May 2025 to present day), a period when core inflation was moving lower from the heighted inflationary period of the 1970s and ’80s.
How should investors respond to this uncertain and odd period where risks from inflation are elevated at the same time the labor market appears to be weaking? As discussed in our Asset Allocation Focus, it has become clear that the “economic tails”, or the range of possible outcomes, are wider than normal. The good news is that our investment philosophy acknowledges these tails, factoring in various outcomes by prioritizing diversification over concentration.
About the Author:
Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.
