Unless data such as Friday’s payrolls stage a remarkable rebound, it looks as if the Fed will cut rates in September and follow this up with more cuts in the future.

Unless data such as Friday’s payrolls stage a remarkable rebound, it looks as if the Fed will cut rates in September and follow this up with more cuts in the future. But the Fed will very likely be cutting rates as inflation is rising. That’s very unusual, almost unique. Proponents of rate cuts believe that the Fed can do this because the source of the inflation – tariffs – is temporary and because longer-term inflation expectations are well anchored close to the Fed’s 2% target. Steven Barrow, Head of Standard Bank G10 Strategy takes issue with both of these assertions.

First up, tariffs may not prove to be the one-off inflation effect that some anticipate. Indeed, as we already may be seeing, price pressures could prove more of a slow-burn process than a quick and instantaneous fire that rapidly burns itself out. One reason for this is the inventory that firms hold at pre-tariff prices. Another is the clampdown on migration that is compounding meager workforce growth, leaving the unemployment rate barely above the Fed’s definition of full employment, which is 4.2%.

This moderation in the growth of the migrant workforce could lift costs considerably in sectors where such workers dominate, like agriculture and construction. These pressures look set to not only persist, but also intensify long after the one-off price lift from tariffs is supposed to have disappeared. The risk is that this embeds higher-inflation as wages remain elevated in order to attract sufficient workers, especially lower down the pay scale. The prospect of the Fed cutting rates at a time of rising inflation might not be so bad if inflation expectations are well anchored, as many Fed members insist.

However, there are new concerns on this front as President Trump tries to push the Fed towards a more dovish bias by criticising Fed Chair Powell, dangle the carrot of Fed Presidency status in front of existing members (Waller and Bowman), and removes policymakers that don’t share his views (Cook). If these actions undermine the Fed’s anti-inflation credibility it could undermine the inflation anchor as well. But while many might see political pressure as the biggest threat to inflation expectations, we do not, although we will admit that these actions are troubling.

Instead, Steven Barrow’s view is that inflation expectations are not really set by the credibility of the central bank amongst the general public but are, instead, more a function of history, or what we might term hysteresis. In short, people come to expect that what has happened in the past will happen in the future. Hence, periods of very low and stable inflation can embed low inflation expectations amongst the population. That’s what we saw between the global financial crisis and the pandemic.

Equally, bouts of sharply higher inflation can lift inflation expectations as people start to see higher prices as the norm. This makes the dramatic surge in US inflation to over 9% in 2021 and 2022 so important. Consumers saw this big surge in inflation and are now more minded to believe that it could happen again, whatever the independence or credibility of the central bank.

Moreover, such inflationary episodes hit home more when they relate to the goods people buy in the shops, or online, than the services they pay for, such as insurance. And with tariff-related inflation most likely to be felt in goods prices, we see a fair bet that inflation expectations won’t be as well anchored as the Fed, and perhaps investors, seem to think. But what are the financial market implications of such a view?

“The primary effect will likely be seen further down the treasury curve. It is one reason why we see the 10s-2s curve steepening to around 150-bps by the end of next year from around 60-bps at the moment. As for the dollar, much depends on whether unanchored inflation expectations push the Fed to keep policy tighter but, given the political factors at play right now, that looks less likely. If so, the dollar looks more vulnerable as well, and that helps inform our call for euro/dollar to rise to the 1.30-1.35 range over the next year, or two”, said Steven Barrow.