Investors are eagerly awaiting a resumption of US Federal Reserve interest rate cuts in the second half of the year, even as the benefits of such a move risk being offset by resurgent inflation or weakening labor trends.
The US unemployment rate is projected to hover near historically low levels at 4.24% this year, according to SP Global Market Intelligence data. Meanwhile, the most recent core personal consumption expenditures index reading, the Feds preferred gauge of inflation, showed a 2.7% year-over-year increase in May as it continued to resist cooling toward the central banks 2% target. The headline metrics are influential in guiding the Feds dual mandate of encouraging maximum employment and stable prices through rate policy.
The Fed held its benchmark interest rate between 4.25% and 4.50% during the first half of the year amid labor market stability and concerns that a premature rate cut could aggravate the stubbornly elevated inflation rate, especially as price increases face upside risk from on-again-off-again US tariff policy. Yet markets are still pricing in a probability of over 60% that the Fed will cut rates in the coming months, according to CME FedWatch data as of July 24.
Everyone likes a rate cut cheaper money fuels growth but cutting rates when inflation is stable or rising, especially amid new tariff pressures, could worsen inflation, Stephan Shipe, founder and CEO of Scholar Financial Advising and finance professor at Wake Forest University, told Market Intelligence. That said, some market participants would still cheer a cut because of the boost it would give to valuations.
Equities have rallied since President Donald Trump pulled back in April from fully enforcing a planned slate of global tariffs, which initially triggered a market sell-off. The SP 500, for example, was up nearly 28% on July 24 from a recent low on April 8, the day before the tariff pause was announced. A subsequent string of trade deals has also bolstered market optimism.
Yet if inflation pressure refuses to subside, market stakeholders wishing for steady rate cuts may need to wait for clear signs of deterioration in employment trends. In that scenario, the tailwind of a rate cut would be met with the potential headwind of a slowing economy.
While yes, it is a disconnect to wish for shakier economic data to get a needed rate cut, it is common that politicians and market participants call for lower interest rates due to their rather fast effect on liquidity, or money moving through the market, and what that can do to stimulate growth, Rebecca Homkes, lecturer at the London Business School and faculty member at Duke Corporate Executive Education, told Market Intelligence. What we need to consider is if inflation spikes over the next few months, the Fed could see itself back in a rate-hiking cycle.
Complicating factors
The markets probability of two rate cuts later this year aligns with the Feds own projections released in June. Market expectations for 2026, however, are more varied, and Fed officials have become increasingly divided in their views.
Some of this uncertainty stems from the view that the Fed has overestimated the potential impact on inflation from tariffs, according to Arnim Holzer, global macro strategist at Easterly EAB.
Were getting a more modest impact because of corporations ability to generate margin, whether through AI or through other systematic improvements and efficiency, so that theyre able to take some of the impact of tariffs into their margins and still generate decent returns, Holzer said in an interview. The earnings are coming in fine, so the question is whether the Fed will give some liquidity at a time when its not absolutely necessary.
Second-quarter earnings releases have mostly generated optimism among investors, especially as results compare favorably to lowered estimates for the quarter.
Beyond the murky outlook for inflation, the projected path of rate cuts is also clouded by worries that the Trump administration may influence Fed decision-making.
The White Houses recent questioning of Fed Chair Powell and the accompanying threats to fire him represents a far greater source of potential market volatility right now than the relatively small disconnect between market and Fed expectations on interest rates, John Canally, chief portfolio strategist at TIAA Wealth Management, told Market Intelligence.
Fed decisions may also be influenced by the Trump administrations actions if rate cuts are necessitated due to increased government spending facilitated through the One Big Beautiful Bill. In this case, markets could reasonably anticipate additional rate cuts in 2026 without significant weakening in employment data or easing in inflation.
There is no contradiction if we believe market participants are in the process of adapting to a fiscal dominance regime, Chun Wang, senior analyst and co-portfolio manager at Leuthold Group, said in an email to Market Intelligence. This is where Fed policymaking will take a back seat to fiscal decisions. With debt and deficits at current levels and going higher, the Fed will have to cut rates and let inflation run hot.
