The next stage of the FOMC's rate-cutting cycle is just beginning

So long summer, hello rate cuts

Summer has come and gone, but the next stage of the FOMC's rate cutting cycle is just beginning. We look for the FOMC to cut the federal funds rate by 25 bps at each of its next three meetings, pushing the target range down to 3.50%-3.75% by year-end. We project two more 25 bps rate cuts at the March and June meetings next year, resulting in a terminal fed funds rate of 3.00%-3.25%.

The U.S. labor market is in a precarious position, in our view, and this is the primary driver of our more dovish monetary policy outlook. The three-month moving average on nonfarm payroll growth was a measly 29K in August, and data from private sector sources corroborate the trend in the BLS data. Slowing labor supply growth can account for some of this deceleration, but the unemployment rate hit a fresh cycle-high of 4.3% last month, and the soft data continue to point to souring sentiment among workers about job availability.

Admittedly, the inflation half of the Fed's dual mandate remains in tension with additional rate cuts. The core PCE deflator is up 2.9% year-over-year and at a 3.0% annualized pace in the three months ended in July. Rising prices for physical goods have kept inflation stubbornly above the central bank's 2% target despite tamer service sector inflation since the start of the year.

Although progress has stalled on bringing inflation back to 2% this year, the rise in prices since Liberation Day largely has been in line with economist expectations. Furthermore, economic theory tells us that the supply-side inflation from higher tariffs should be transitory as long as inflation expectations remain anchored, and inflation expectations generally have been well-behaved of late.

Continued above-target inflation will keep the FOMC from cutting below neutral for the foreseeable future, in our view, but with the fed funds rate still 100 bps-150 bps above our estimate of neutral, there is capacity to support the labor market without overdoing it.

With so little forward momentum in the labor market, near-term recession risks have ticked higher. We assign a 35% probability of a recession in the United States in the next 12 months, and the next six months or so strike us as the most precarious stretch as higher tariffs and restrictive monetary policy continue to bite.

As we look ahead to 2026, we feel more optimistic about the outlook for economic growth. Fiscal stimulus is coming next spring when households file their taxes and take advantage of the tax cuts enacted in the One Big Beautiful Bill. The lagged effect of monetary policy easing should start to be felt next year, and as long as there are no more major increases in tariff rates (we grant that is a big caveat), the hit to economic growth from higher tariffs should gradually fade as 2026 progresses. We look for an above-consensus 2.4% Q4/Q4 growth rate for real GDP next year.

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