Fed Walks a Delicate Balance Amid Labor Weakness, Stubborn Inflation

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

For the past several months, investors and the Federal Reserve have remained locked in the same debate: Does stubborn inflation—currently hovering above the U.S. central bank’s 2 percent target for nearly the fifth year running—or slowing labor market growth pose the largest risk for the economy?

Until the long-term economic outlook becomes clearer, the Fed must continue to strike a delicate balance in its dual mandate to support the labor market while keeping inflation under control. This mission is hardly anything new: Monetary policymakers have been walking the same tightrope since 1977, when an amendment to the Federal Reserve Act directed them to target “maximum employment, stable prices, and moderate long-term interest rates.”

So why, after all these years, has this balancing act become more difficult than ever? There are a few key factors at play that have thrown the Fed increasingly off kilter.

First, policymakers currently have less information at their disposal to fuel their decision-making. Before the government shutdown, conflicting indicators of persistent inflation posed by tariffs versus a softening labor market and robust economic growth had already muddied the long-term economic outlook. The subsequent lack of federal reports on jobs, inflation and more has left the Fed to rely on more-limited private-sector data to decode these mixed signals, making it harder to know whether the economy needs easing or tightening.

Meanwhile, an increasingly bifurcated economy has cast further uncertainty over the Fed’s dual mandate. Following the Fed’s rate hikes in 2022 and 2023, interest rate-sensitive parts of the economy—think manufacturing, housing, smaller companies and lower- to middle-income consumers—have experienced slower growth, while high-income consumers who own stocks and benefit from cash balances earning higher rates of interest, along with Large-Cap companies tied to the artificial intelligence boom that are less interest rate-sensitive, benefited most.

These increasingly divergent economic realities, often referred to as a “K-shaped” economy in which one set of sectors, industries or individuals continue to gain traction while the other stagnates, make the Fed’s job harder, as a policy that boosts one group may inadvertently drag down the other. Forced to make difficult trade-offs, this has led to deep internal divisions within the U.S. central bank.

The Fed is widely expected to cut interest rates by 25 basis points for the third consecutive time this month following weak U.S. jobs data and an inflation reading that—while still above the Fed’s 2 percent target—has not substantially risen. We also saw signs of the bifurcating economy weakening slightly as consumer spending dipped in September amid continually elevated prices and consumer sentiment hit a new low in recent months (more on that in the Wall Street Wrap below). Even with the market pricing in a 99 percent chance of another rate reduction, however, we believe there is likely to be dissent among Fed policymakers given concerns over future inflationary pressures.

This did little to quell investor enthusiasm, however, as the S&P 500 continued to push higher on hopes of another rate cut later this week. In fact, the market’s trajectory over the past few weeks has been strongly tied to the perceived path of a December rate cut. After rising to a record 6890 at the end of October amid the market’s 100 percent appraisal of a third rate cut this year, markets retreated in mid-November as rate cut expectations plunged to 29 percent. Since then, the market has rebounded to 6892 as rate cut expectations have risen to nearly 100 percent.

The big question now is how long this delicate balance will be sustainable, particularly given today’s historically narrow market. The past two years are among the narrowest market advances on record, with around 30 percent of the members of the S&P 500 actually beating the index—tied for the least amount and reminiscent of 1998 and 1999, when the dot-com boom coupled with corporate Y2K spending pushed a bifurcated economy and equity markets to new heights. Today, the AI frenzy may repeat history, as companies wielding the “technology du jour” generate outsize earnings growth.

We are confident that the equity market breadth will widen in the coming years as the benefits of AI continue to push more broadly into the U.S. economy and markets, perhaps even helped along by renewed monetary easing from the Fed and the passage of fiscal stimulus via the One Big Beautiful Bill Act. Indeed, over the past few months we have seen forecasted earnings growth rise beyond just the tech companies dominating in AI. U.S. Small Caps, in particular, are finally seeing earnings growth estimates rise, which could serve as a catalyst to help close the wide valuation gap with respect to their Large-Cap peers.

This widening won’t happen overnight, however. We remain cautious as the long-term impacts of tariffs continue to materialize in the economy, potentially contributing to further labor market weakness should companies absorb the extra costs.

In the meantime, we continue to prioritize diversification above all else. Rather than concentrating in the areas that have outperformed, a well-balanced portfolio provides a more resilient foundation that can capture gains from a variety of areas while simultaneously buffering against short-term volatility.

Wall Street Wrap

Weak hiring and more firing reflect further labor softening: The latest ADP National Employment Report reflected a loss of 32,000 jobs in November, down from a revised 47,000 gain in October and the most monthly jobs shed since early 2023. This marks the fourth month of the past six when employers have shed jobs. Over the past three months, this report shows that private employment has declined by an average of 4,700 jobs, with the six-month average at 10,7000 jobs added.

Workplace intelligence group Revelio Labs also reported negative job growth for the month of November, with net jobs losses of 8,900 in November following 15.6k losses in October. Similar to ADP’s report, this is the fourth of the past six months that employers have cut jobs, with the three- and six-month averages checking in at 4,500 jobs gained and 2,500 jobs lost, respectively. While we will not get the November national employment report from the Bureau of Labor Statistics (BLS) until December 16, these reports paint a picture of a weakening labor market.

This weaker labor market looks set to continue in the near future, according to the latest report from consulting firm Challenger, Gray & Christmas, which showed 71,321 job cuts in November, up 24 percent from the 57,727 job cuts announced in the same month last year. The good news is that this marks a sharp drop from the 153,074 job cuts announced in October. The bad news is that this is only the second time that November job cuts have surpassed 70,000 since the Great Financial Crisis.

“Layoff plans fell last month, certainly a positive sign. That said, job cuts in November have risen above 70,000 only twice since 2008: in 2022 and in 2008,” said Andy Challenger, the firm’s workplace expert and chief revenue officer. Year to date through November, companies have announced 1,170,821 job cuts, up 54 percent from last year’s 761,358 and the highest since 2020 and, before that, 2009, when the U.S. economy was emerging from the Great Financial Crisis.

The Challenger report also shows weak hiring, with U.S. employers announcing just 497,151 planned additions from the beginning of the year, a 35 percent drop from the 761,954 announced during the same period in 2024. This marks the lowest year-to-date planned hires since 2010 (as the country exited the financial crisis), when 392,033 new hires were planned through November. In contrast, initial jobless claims came in at a more than three-year low of 191,000 in November. It’s worth noting that the latest unemployment claims data stemmed from the shortened Thanksgiving holiday week, which has historically produced big swings. Nonetheless, the totality of all the recent labor market data paints the picture of a “low hiring, low firing” trend that could be transitioning to one of even lower hiring and possibly more firing.

Stable prices bolster rate cut expectations: The core personal consumption (PCE) expenditures price index, a favored price gauge of the Fed that excludes volatile food and energy prices, rose 0.2 percent in September, while the annual rate was 2.8 percent. Headline PCE increased 0.3 percent for the month, placing the annual inflation rate at 2.8 percent as well.

Widely in line with expectations, the delayed report suggested that prices remained relatively stable despite tariffs and resilient consumer spending—reinforcing expectations that the Fed will opt to cut rates and prioritize boosting employment. However, three-, six- and nine-month core CPI has consistently hovered between 2.7 and 3 percent on an annualized basis, underscoring how sticky inflation has become.

This report also contains details on consumer spending, which showed a marked slowing in the month of September. Overall spending stalled in September, according to the U.S. Bureau of Economic Analysis, with consumer spending up 0.3 percent. But with headline PCE also up 0.3 percent, real personal spending amounted to 0 that month in a sign of growing consumer weakness. On a year-over-year basis, real consumer spending is up 2.1 percent, which is the lowest reading since January 2024.

Consumer sentiment remains low amid stubborn inflation: The University of Michigan’s Consumer Sentiment Index rose 2.3 points to 53.3 in December, according to preliminary data, its first increase in five months. The December results are still very low, however, nearing the 50 points reached in June 2022—the lowest reading since data began to be collected in 1978. Consumers’ assessment of the future drove the advance, rising four points to 55, while their assessment of their current situation fell 0.4 points from last month to 50.7, which is the lowest reading ever observed in this survey since its inception nearly five decades ago.

On the positive side, both the one-year and five-year consumer inflation expectations fell, with the latter falling to 3.2 percent from 3.4 percent, the lowest reading since January of this year and down from its recent peak of 4.4 percent in April. Consumers’ assessment of the labor market improved a touch, albeit still at levels historically consistent with periods of economic contraction. The percentage expecting more unemployment in the next year fell to 63 from 69 in November, which was just short of the all-time high of 72 set back in May 1980.

The report release noted these minor improvements, stating that while consumers don’t expect an imminent inflation surge, they do expect elevated inflation to persist. It also noted a slight improvement in labor market expectations, albeit at relatively dismal levels.

Services and manufacturing continue to diverge: The Institute for Supply Management (ISM) Services Purchasing Managers Index (PMI) continued to expand in November, albeit at a more modest pace, while the Manufacturing PMI remained in contraction territory for the ninth consecutive month. Taken together, the reports paint a picture of a bifurcated economy characterized by a steadily expanding services sector and persistently contracting manufacturing sector—the latter of which is particularly vulnerable to tariff-related cost pressures and weakening global demand.

Services

The ISM Services PMI came in at 52.6 percent, 0.2 points higher than October’s 52.4 percent reading, a modest progression suggesting that employment concerns and prices are continuing to moderate, even as upward pressure risk remains.

New orders also remained in expansion in November with a reading of 52.9 percent, 3.3 percentage points below October’s figure of 56.2 percent but 0.9 percentage point above the 12-month average of 51.7 percent. Highlighting a still weak employment situation, the Employment Index contracted for the sixth month in a row with a reading of 48.9 percent, a 0.7 percentage point increase from October’s 48.2 percent. The Prices Paid Index came in at 65.4 percent, 4.6 percentage points lower than the 70 percent recorded in October, which was the highest level since October of 2022. While prices slipped back in November, we believe its still-elevated level highlights the potential risks of goods inflation bleeding into services inflation going forward.

Manufacturing

Manufacturing remained weak in November, with only four of the 18 industries surveyed reporting growth, down from six industries in October and representing the lowest figure observed since the three industries recorded in November 2024.

ISM’s Manufacturing PMI registered 48.2 percent for November, a 0.5-point decrease from October. This index has been in contraction territory for 35 of the last 37 months. Readings for new orders reflected contraction for the third consecutive month, coming in at 47.4 percent, though that reading is two percentage points lower than the 49.4 percent recorded in October. New orders have now been in contraction for eight of the past 10 months. Similarly, order backlogs remain light, with that index remaining in contraction at 44 percent, marking the 37th consecutive month in contraction territory. The Employment Index remained in contraction for the 10th month in a row, while prices paid inched up to 58.5 from 58.

The week ahead

Tuesday: The National Federation of Independent Business (NFIB) will release its Small Business Optimism Report, which covers the economic health and outlook of small businesses. Last month’s findings showed a slight decline in small business optimism; however, the uncertainty index fell to its lowest reading of the year. We’ll be watching to see how small business owners respond to continued inflation pressures and labor market challenges.

The U.S. government is also expected to release the Job Openings and Labor Turnover Survey which details job openings, hires and separations, for October on Tuesday, while the much-watched Employment Situation report detailing nonfarm payrolls and unemployment for November will be delayed until mid-December due to the recent government shutdown.

Tuesday/Wednesday: The Federal Open Market Committee meeting is scheduled for December 9–10. A statement on monetary policy will be released at 2pm ET on day two, followed by Chair Powell’s press conference. We will also get the updated dot plots.