A Divided Fed Cuts Rates, but Delicate Balance Remains

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

All eyes were on the Federal Reserve as it opted to lower the federal funds rate by 25 basis points to a target range of 3.5 to 3.75 percent at its December 10 meeting, the third consecutive reduction this year. The decision drew little surprise: The market had been pricing in nearly a 90 percent chance of another cut amid a softening labor market and signs of easing yet still stubborn inflation. But a remarkable level of dissent among Fed officials hinted at an increasingly divided committee behind the scenes, suggesting that policymakers’ decision-making process going forward will be anything but straightforward.

The 9–3 vote marked the most divisive result in over six years. Of the three members who voted against the decision, two wanted to keep interest rates as is, while one, Stephen Miran—the Fed’s newest member, who was previously a top economic advisor to President Donald Trump—wanted a larger half-point cut. Those growing divisions become clearer upon review of the U.S. central bank’s infamous dot plot, which revealed six total Federal Open Markets Committee members who penciled in no cut at December’s meeting. As a reminder, there are 12 regional Fed bank presidents, but only five of them vote on a rotating basis alongside the seven Board of Governors. In other words, of the 19 Fed members with the potential to vote, six voted for no change, with the aforementioned Miran’s being the one who voted for an even larger cut.

This unusually splintered vote reflects the increasingly narrow path the Fed must walk in its dual mandate to ensure maximum employment while keeping prices under control. On one hand, keeping rates as is risks turning an already stagnant “low hiring, low firing” labor market into one of even lower hiring and potentially more firing. On the other, cutting rates too aggressively could risk reigniting inflation, which, despite remaining steady in recent weeks, remains stubbornly above the U.S. central bank’s 2 percent target.

This delicate balance shone through in the Fed’s dot plot, projecting only one interest rate cut for 2026 and signaling a “slow and steady” approach to future cuts going forward. “In considering the extent and timing of additional adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook and the balance of risks,” the Federal Open Markets Committee noted in a statement following last week’s meeting.

Historically, such language has been used to hint at a pause in monetary policy, a message that was reinforced by Fed Chair Jerome Powell on Wednesday, stating that the U.S. central bank is “well positioned” to await further clarity on where inflation and the labor market are headed. Even so, the variation of insights from the dot plot show that it is far from a crystal ball.

Despite showing one cut for 2026, three members anticipated that the Fed will actually need to raise rates next year, which would qualify as a surprise, while four expect rates will remain the same. With seven members leaning toward either no change or a raise in rates, the overall expectation to cut rates suddenly looks less black and white. Factor in the likely change in leadership at the helm of the U.S. central bank, with Director of the National Economic Council Kevin Hassett and former Fed governor Kevin Warsh speculated as potential replacements for an outgoing Powell in May, and the scales could be tipped even further. Trump told the Wall Street Journal on Friday that both candidates were at the top of his list.

“This is such a unique situation,” Powell noted, emphasizing the rare “tension” that currently exists between its dual mandate as the labor market continues to face significant downside risks and tariffs continue to fuel above-target inflation. So why, if the line is so thin, did the Fed opt to cut rates this time around?

We have consistently highlighted the weak labor market, characterized by weak hiring and rising unemployment claims. Recall that in September, when the U.S. Bureau of Labor Statistics (BLS) reported a preliminary downward revision of 911,000 jobs to total nonfarm payrolls in the 12 months to March 2025, a significant correction was driven largely by overestimates in retail, hospitality and business services. This suggested the U.S. economy added significantly fewer jobs monthly (around 76,000 less) during that period, painting a gloomier picture of labor market strength.

That trend appears to have continued, according to nonfarm payrolls through September, which have averaged around 39,000 per month since April. However, those figures could be overstated by as many as 60,000 jobs, Powell noted in his speech, which would amount to a negative 20,000 jobs per month. Furthermore, the majority of this nonfarm payroll growth was fueled by education and health services, which, for a sector that makes up only 17 percent of total U.S. employment, has been doing an outsize portion of the heavy lifting when it comes to hiring.

At the same time, the dot plot forecasted that inflation, measured by Personal Consumption Expenditures, will slowly decline from its current rate of around 2.9 percent to 2.4 percent by the end of 2026—and won’t meet the Fed’s 2 percent goal until 2028. In other words, the consumer will likely be faced with persistent, albeit easing, price pressures over the next three years, helping fuel the two dissenters' votes as well as the other four who would have voted no.

Powell has reiterated time and time again that the Fed’s “base case” outlook is that tariffs will result in a “one-time shift in the price level,” not a persistent push higher. Nonetheless, the reality is that goods inflation has ticked upward as the longer-term impacts of tariffs begin to work their way into the economy, while services inflation has begun to slow. The current inflation overshoot is being caused by tariffs, Powell noted, adding that the Fed believes it will subside as we move through 2026.

Going forward, what does this mean for investors? The level of dispersion among Fed votes on interest rates reflects lingering uncertainty over the economy, reinforcing the need to prioritize diversification in order to avoid emotional decision-making, avoid overconcentration in any single area and provide more stable, long-term growth potential.

The Fed now has cut rates by a total of 1.75 percent over the past year. That should help alleviate some of the pressure that has been placed on the more interest rate-sensitive parts of the economy and equity markets over the past couple years following an aggressive campaign of interest rate hikes in 2022 and 2023 (totaling 5.25 percent) to combat high inflation. It was that period of more hawkish monetary policy that led to the current bifurcated state of the economy and markets, which has become increasingly segmented as leaders of the artificial intelligence revolution—from Big Tech developers to hyperscaler builders—have experienced disproportionate growth and investment, while other sectors have lagged.

Much as with the dot-com boom in the late 1990s, however, we anticipate a similar broadening in the coming years as AI and technological advancements increasingly permeate the broader economy, helping bridge the economic divide, boost the job market and potentially ease long-term inflationary pressures.

We saw the beginnings of this expansion last week, as the S&P 500 fell 0.63 percent amid a 2.3 percent decline in its largest sector, technology. The equal-weighted S&P rose 0.74 percent as a result, propelling more interest rate-sensitive Small-Cap stocks (S&P 600) up 2.02 percent and Mid-Cap stocks (S&P 400) up 0.93 percent. This potential economic and market broadening comes at critical juncture as questions mount over the sustainability of current AI spending.

These questions were amplified this past week, when enterprise software giant Oracle’s earnings fell short of expectations, sending its stock plummeting more than 45 percent from its September high and raising concerns about its AI ambitions following its deal to provide $300 billion worth of AI cloud computing services to Microsoft’s OpenAI.

As discussed in our latest Asset Allocation Focus, we believe the answer to how you should respond to this increasing uncertainty is the same now as it as was when the dot-com bubble burst: continuing to prioritize diversification and maintaining a carefully balanced portfolio to weather short-term obstacles while targeting long-term gains.

Wall Street wrap

Jobless claims increase but remain steady on average: Initial jobless claims jumped to 236,000 for the week ending December 6, marking a significant 44,000 increase from the prior week, the largest rise in over four and a half years. However, we note that volatility often follows the Thanksgiving holiday week, with the four-week average remaining stable at 216,750. All signs point to continued cooling in the labor market.

Small business optimism rises despite stubborn inflation: Optimism among small businesses rose by 0.8 points in November, according to the latest data from the National Federation of Independent Business, rising to 99 and remaining above its 52-year average of 98.

A seasonally adjusted net 19 percent of small business owners reported plans to create new jobs in the next three months, up four points from October and the highest reading of the year. The last time hiring plans reached this level was in December 2024. Despite increased hiring plans, however, actual employment has remained down by a seasonally adjusted net -3 percent over the past three months, a historically low figure.

Meanwhile, the net percentage of owners raising average selling prices rose 13 points in October to a seasonally adjusted 34 percent, the highest reading since March 2023 and the largest monthly jump in the survey’s history in a sign of persistent inflation.

In a more upbeat signal, 21 percent of small business owners cited labor quality as their most pressing issue, a six-point decrease from October’s notable spike. This figure came in six points above inflation, which ranked as the second most important problem facing small businesses.

On the downside, a seasonally adjusted 33 percent of business owners reported job openings they could not fill in the current month, with unfilled job openings remaining well above the historical average of 24 percent. Additionally, a seasonally adjusted net 26 percent of owners reported raising compensation, unchanged from October. This is tied for the lowest plan to raise worker pay since COVID-19, suggesting that labor tightness remains historically high.

In another negative sign, the net change in actual sales over the past three months fell by a seasonally adjusted -9 percent, while actual earnings changes fell by a net -23 percent over the same period. On the bright side, however, the net percentage of owners expecting higher real sales volumes over the next three months rose nine points from October to a net seasonally adjusted 15 percent, helping propel the Optimism Index’s recent rise.

These sunnier expectations could be tied to lower interest rates, as small businesses become more likely to secure better terms on loans after the Federal Funds Rate was raised by a total of 5.25 percent in 2022 and 2023. Should this trend continue, we could see it help usher in a broadening economy and market.

The week ahead

Tuesday: The BLS will release a crucial November Nonfarm Payrolls report at 8:30am. The delayed report, originally scheduled to be released on December 5 but delayed by the government shutdown, will also include nonfarm payrolls for October.

Tuesday: Standard & Poor’s will release its preliminary Global U.S. Manufacturing and Services Purchasing Managers Index. Services Purchasing Managers Index (PMI) data continued to expand in November, albeit at a more modest pace, while the Manufacturing PMI remained in contraction territory for the ninth consecutive month. We’ll be watching to see whether these trends continue.

Tuesday will also bring fresh data on retail sales for October from the U.S. Census Bureau, providing a barometer on the strength of the U.S. consumer amid heightened bifurcation and stubborn inflation.

Thursday: The BLS will release the Consumer Price Index for November at 8am ET, a critical inflation report. Last month’s data, which was delayed as a result of the shutdown, came in softer than expected on Friday despite ongoing worries about the effects of higher tariffs.

Friday: Final December 2025 data for the University of Michigan’s Consumer Sentiment Surveys is scheduled to be released at 10am ET. Preliminary data showed that the Consumer Sentiment Index rose 2.3 points to 53.3 this month, its first increase in five months. A full summary of the preliminary data can be found in last week’s Commentary.