Is the Projected Path of Fed Easing Too Aggressive?

Yes. Current market expectations for the Federal Reserve to lower its policy rate by roughly 150 basis points (bps) by the end of next year are overly optimistic. While we expect a 25-bp cut on September 17, we believe additional cuts through 2026 will be more gradual than markets anticipate, given persistent inflation and a labor market that, while softer, remains resilient. If the Fed cuts rates slowly, long-term US Treasury yields are unlikely to fall much further, favoring a neutral duration stance. Nevertheless, even gradual rate cuts are likely to weaken the US dollar, as the gaps in short-term interest rates and economic growth between the United States and other countries narrow.

The Fed is weighing whether to lower its policy rate from 4.25%–4.50% at its September meeting, which would mark the first cut since December. After reducing rates by 100 bps in the second half of 2024, the Fed paused to assess the impact, as robust growth, a strong labor market, and sticky inflation limited the case for further cuts. In 2025, US growth has slowed—real GDP rose 1.4% in the first half versus 2.5% in 2024—while core CPI remained elevated at 3.1% in August and higher tariffs threaten to add to inflation. In July, the Fed held rates steady, citing inflation risks. However, newly revised data revealed a much softer labor market—the three-month average pace of job growth fell to 29,000 in August, down from 209,000 when the Fed last cut rates. This shift has increased the likelihood of a rate cut this month.

Looking ahead, markets expect a swift path for policy easing, with 75 bps of total cuts by year end and another 75 bps in 2026. This contrasts sharply with the Fed’s June projections, which indicated three total cuts through 2026. While the Fed’s outlook may have shifted as inflation and employment risks have evolved, market pricing remains notably more aggressive. Based on the Taylor rule, ¹ the current policy rate is only modestly restrictive. For the Fed to deliver the market’s expected cuts, core inflation would likely need to fall below 2% or unemployment rise above 5%—neither outcome appears likely. There is also considerable uncertainty about how restrictive policy truly is, given the resilience of the US economy. Separately, the Fed’s updated long-term framework signals a more proactive approach to fighting inflation, reflecting lessons from the 2021–22 period when policy lagged. All of this suggests the Fed will be cautious in its approach to easing.

While we expect a gradual easing cycle, a sharper downturn in growth or a significant erosion of Fed independence could prompt more aggressive rate cuts. Although US recession risk appears low, slowing growth and rising cost pressures from tariffs or inflation could further squeeze corporate profit margins and consumer spending. The secular trend of AI has helped counterbalance cyclical headwinds, but this may not pan out as expected. Fed independence also faces its greatest challenge in decades, with the Trump administration repeatedly calling for rate cuts and openly discussing replacing Chair Jerome Powell before his term ends in May. The recent attempt to fire Fed Governor Lisa Cook over alleged mortgage fraud is unprecedented. While legal and policy barriers make it difficult for the president to remove a Fed governor or directly influence policy, heightened political pressure alone tends to result in lower rates and higher inflation over time.

Still, we expect US economic growth to remain positive and the Fed to maintain its independence in setting policy. The Fed should be able to lower rates, but likely less than markets anticipate. In this environment, front-end Treasury yields may decline, while long-end yields could stay elevated as inflation, fiscal, and policy uncertainty keep term premiums high. Narrowing short-term interest rate and growth differentials between the United States and other major economies will likely further weaken the US dollar, which has already fallen this year but remains overvalued. Markets have mostly shrugged off political attacks on the Fed, but any significant erosion of its independence—though not our expectation—would likely compound these pressures, steepening the yield curve and adding to dollar weakness.

Given these dynamics, investors should temper expectations for a rapid Fed cutting cycle. We recommend maintaining a neutral duration stance versus policy and modestly tilting toward non-US assets, such as unhedged developed markets ex US government bonds or global ex US equities, which stand to benefit from a weaker dollar.

Footnotes

1. The Taylor rule is an equation that prescribes a value for the federal funds rate based on inflation and the output gap.