After the European Central Bank signalled that its policy rates would not fall further, the US Federal Reserve restarted its cycle of interest rate cuts.
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As expected, the Fed concluded its nine-month policy hold by cutting the benchmark federal funds rate by 25bp on 17 September and signalled additional easing at its two remaining 2025 meetings. Market pricing suggests further rate cuts – in March and June 2026.
Somewhat counter-intuitively, this dovish shift in its stance has come at a time of notable upward revisions in the Fed’s statement of economic projections (SEP) for inflation and growth and a downtick in the unemployment rate.
The dual mandate – Choosing between the plague and cholera
The Fed’s dual mandate, stipulating that it shall ensure stable prices and maximum employment, requires policymakers to make a call between the importance they attach to each objective at any one time. Both the US unemployment rate and the inflation rate have been rising, so which matters more?
It appears clear that central bank policymakers are willing for the economy to run a little hotter in 2026 as the price to pay for making sure the employment problem doesn’t get worse.
As Exhibit 1 shows, relative to the last SEP, from June 2025, the Fed expects GDP growth and inflation to be slightly higher, but it anticipates the federal funds rate to be lower at the end of 2026 (3.4%, versus a projection of 3.6% in June).
Admittedly, policymaker expectations for the median rate were pulled down by Stephen I. Miran, the Fed’s Board of Governors newest member, sworn in on 16 September, just in time for this meeting after his nomination by President Donald Trump.
Dr Miran’s first vote marks him as a potential outlier. He thinks the fed funds rate should fall by 1.25% this year. He cast the sole dissenting vote for a 50bp cut at the meeting. The two Trump appointees who dissented from the decision in July not to cut rates, Michelle Bowman and Christopher Waller, voted for 25bp along with the other voting members.
Jobs are a concern, inflation less so currently
During his press conference, Chair Jerome Powell emphasised that the Fed currently gives more importance to the employment side of its mandate than inflation.
Both have been rising, so a choice has to be made. In Powell’s view, it can no longer be said that the labour market is ‘very solid’. He was specific in saying that “Labour demand has softened, and the recent pace of job creation appears to be running below the breakeven rate needed to hold the unemployment rate constant.”
The Fed is prepared to tolerate higher inflation
Our fixed income team believes that the US labour market has been weakening significantly, with demand for workers falling faster than constrained supply. While we do not see any major imbalances in the US economy that would give cause for concern, the weaker labour market data does raise questions about the prospects for US growth.
The Fed’s tolerance of inflation running at around 3% relative to its 2% target could be justified on the basis that a softer labour market may mean wage-driven second round inflation effects from the tariffs on imported goods are less likely.
Leading to a steeper US yield curve
We expect US policymakers will cut rates by 25bp in both October and December and by at least 75bp more in 2026 to take the terminal fed funds rate to 2.75-3.00% or below for this cycle.
With President Trump likely to keep up his pressure on the Federal Reserve for an even looser monetary policy, we expect the bond yield curve to steepen as longer-dated yields rise in response to the prospect of above-target inflation.
ECB’s sole focus is on inflation
At its policy meeting on 11 September, the ECB kept its benchmark rate unchanged at 2%. Unlike the Fed, the ECB’s primary objective is price stability. This it has defined as 2% inflation over the medium term.
This month, the message from the ECB is that, barring any major shocks, this cycle of interest rate cuts has ended.
The central bank emphasised the resilience of the eurozone’s economy despite higher US tariffs on most of the bloc’s goods. Its cycle of rate cuts began in July 2024 and has resulted in a halving of borrowing costs in the eurozone.
While in the US, the Fed is prepared to tolerate inflation running significantly above its target, the ECB is more cautious, ignoring its own forecasts of inflation running at a level slightly below its 2% target in coming months.
The ECB sees the inflation ‘undershoot’ as temporary. The coming months will tell whether disinflationary pressures rise further, due perhaps to a possible export push from China or subdued household demand in the eurozone along with fiscal uncertainty.
We would not rule out further rate cuts from the ECB, but not until 2026 when it will be clearer whether below-target inflation in the eurozone is transitory.
A weaker US dollar?
The dollar weakened significantly in the first half of the year despite support from the interest rate differentials. That support is dissipating as the Fed restarts its easing cycle, while ECB policy is on hold.
This week the US dollar softened slightly versus the euro. We expect this trend to continue not so much on account of the interest rate differentials, but simply because diversification out of US assets is likely to continue as investor adherence to the theme of US exceptionalism subsides.
