With Inflation and Unemployment on the Rise, the Fed Signals Rate Cuts

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

Markets last week responded to mixed economic signals with modest gains. The big focus for investors, however, was Federal Reserve Chair Jerome Powell’s address at an annual conference hosted by the Reserve Bank of Kansas City in Jackson Hole, Wyoming. Market watchers were waiting to see whether Powell would shed light on the likelihood of an interest rate increase at next month’s Fed meeting.

Heading into the event, investors were continuing to price in a declining probability of a 0.25 percent September rate cut (although it remained the most likely outcome). As recently as August 13, markets had priced in a 107 percent chance of a September cut (meaning investors were predicting that more than one cut was possible). That number dropped to 85 percent on August 15 following the release of hard data that showed high inflation and fell to 71 percent on Friday morning before Powell’s speech.

The cause of this decline was stronger than expected S&P Global Purchasing Managers Index (PMI) readings for both services and manufacturing, which demonstrated accelerating growth and rising price pressures. In addition, the release of the minutes from the Fed’s July meeting showed that a majority of members believed inflation risks outweighed the risks of a weakening labor market. It should be noted, however, that the meeting was held two days before significant downward revisions in Bureau of Labor Statistics (BLS) job data for May and June. Over the past few weeks, the impact of the Trump administration’s tariffs has begun to show up in hard economic data. The latest Consumer Price Index (CPI) reading from the BLS showed core inflation, which excludes volatile food and energy costs, rising at the fastest annual pace in five months. Meanwhile, last week’s U.S. Composite PMI from S&P Global indicated that companies are starting to pass tariff-related cost increases on to consumers.

At the same time, the data is increasingly pointing to a cooling labor market. The number of Americans filing for unemployment rose last week, and we are now seeing the highest level of continuing jobless claims since November 2021. As mentioned above, the revised jobs numbers for May and June strongly indicated a weakening labor market. And consumers expect higher unemployment in the future, according to survey results released by the University of Michigan two weeks ago. The combination of high inflation and increasing unemployment threatens to violate both sides of the Fed’s dual mandate of maximum employment and stable prices. These dynamics make it harder for the Fed to determine which side to focus on and for investors to weigh the path forward.

We have believed that, given these competing objectives, the Fed would likely err on the side of attempting to strengthen the labor market by lowering rates. Powell’s remarks on Friday support this view. “The balance of risks appears to be shifting,” Powell said, and “the shifting balance of risks may warrant adjusting our policy stance”—i.e., cutting rates after holding them steady in 2025. While he acknowledged that inflation was higher than desired, he said a “reasonable base case is that the effects will be relatively short lived—a one-time shift in the price level. Of course, ‘one-time’ does not mean ‘all at once.’ It will continue to take time for tariff increases to work their way through supply chains and distribution networks.” In saying this, Powell appears to be giving the Fed clearance to cut rates even if inflation continues to rise in the next few weeks. While the size of a potential rate cut will still likely depend on August’s job numbers, a rate cut of some sort now seems more likely, with the probability leaping 10 points to 81 percent.

Markets responded well to Powell’s address, with major stock indexes jumping at least 1.5 percent, with economically sensitive U.S. small caps leading the way with a 3.8 percent gain. That came after a week during which some AI and tech stocks stalled for a few days and against a larger backdrop of doubts about the long-term viability of AI investments. A recent report published by MIT’s NANDA initiative argues that for 95 percent of companies, generative AI implementation is failing to cause significant revenue increases due to flawed integration.

Whether or not AI and tech stocks continue to lead the market higher, reports like this should serve as a caution not to invest only in narrow swaths of the market. Likewise, investors need not position themselves for a particular outcome regarding inflation, the labor market or interest rates. The solution is the same as it has always been: diversification among a wide range of assets, guided by your unique financial plan. While diversification is always the wisest path, it becomes even more important in times like these, when multiple outcomes are in play.

Wall Street wrap

Forward-looking indicators show persistent economic challenges: The latest Leading Economic Index (LEI) report from the Conference Board weakened slightly. The July LEI reading showed a decline of 0.1 percent after falling 0.3 percent in June. Over the six months between January and July 2025, the LEI fell at a 5.3 percent annual pace. The six-month diffusion index (the measure of indicators showing improvement versus declines) remained at 40 percent, marking the fourth consecutive month of levels that have historically coincided with economic contractions.

“While the LEI’s six-month growth rate remains negative, it improved slightly in July—but not enough to avoid triggering the recession signal again,” Justyna Zabinska-La Monica, senior manager, Business Cycle Indicators at the Conference Board, noted in remarks released with the report. “Despite that, the Conference Board does not currently project a recession, though we do expect the economy to weaken in H2 2025 as the negative impacts from tariffs become more visible. Overall, real GDP is projected to grow by 1.6 percent year over year in 2025 before slowing in 2026 to 1.3 percent.”

More mixed indicators from S&P Global: Preliminary data from the latest S&P Global PMI showed that the pace of overall growth accelerated in August. The latest report, which tracks both the manufacturing and services sectors, gives a Composite Output Index reading of 55.4, up from July’s reading of 55.1 and now at its highest level in eight months. Levels above 50 signal growth.

The manufacturing PMI for August was 53.3, up 3.5 points from July’s final reading and the highest level in 39 months. The Manufacturing Output Index climbed 3.9 points to 55.2, also the highest level in 39 months. Meanwhile, the Services Business Activity Index came in at 55.4, down 0.3 points from July. Still, the services sector saw its highest level of demand since December 2024, driving growth in sales. Hiring also rose, as service providers took on employees at the fastest pace since January. Chris Williamson, chief business economist at S&P Global Market Intelligence, said the data indicated that the economy is expanding at a 2.5 percent annualized rate, up from the average 1.3 percent expansion seen during the first two quarters of 2025. “Companies across both manufacturing and services are reporting stronger demand conditions but are struggling to meet sales growth, causing backlogs of work to rise at a pace not seen since the pandemic-related capacity constraints recorded in early 2022,” he said.

New orders rose for manufacturers, in part due to companies once again stocking up on inventory in response to concerns about future supply conditions. Stocks of finished goods showed the largest increase since data became available in 2007, while stocks of purchased inputs showed the second-largest increase in the past three years.

Input prices in the manufacturing and services sectors collectively saw their steepest rise since May, while selling prices for goods and services rose at the sharpest rate since August 2022. The prices of goods decreased slightly, but the rise in services prices was the steepest since August 2022. Companies have “passed tariff-related cost increases through to customers in increasing numbers, indicating that inflation pressures are now at their highest [in] three years,” Williamson said. “The resulting rise in selling prices for goods and services suggests that consumer price inflation will rise further above the Fed’s 2 percent target in the coming months. Indeed, combined with the upturn in business activity and hiring, the rise in prices signaled by the survey puts the PMI data more into rate hiking, rather than cutting, territory according to the historical relationship between these economic indicators and FOMC policy changes.”

Existing home sales rise: The National Association of Realtors reported that existing home sales in the U.S. increased by 2.0 percent in July to a seasonally adjusted annual rate of 4.01 million units. The boost was driven by a slight improvement in housing affordability. Rising demand was widespread, with three of four regions reporting increases. Only the Midwest saw a decline for the month, with 1.1 percent fewer units sold than in June. On a year-over-year basis, sales of existing units rose 0.8 percent.

The inventory of unsold homes was 1.55 million units, up 0.6 percent from June and 15.7 percent from a year ago. Unsold inventory is equal to a 4.6-month supply. Historically, a six-month supply of inventory is consistent with moderate price appreciation. The latest inventory numbers suggest prices may continue to climb at a relatively modest pace. The median price for existing single-family homes rose to $422,400 in July, up 0.2 percent from last year.

Homebuilders’ confidence remains low: Homebuilder confidence weakened this month as buyers continued to be wary of high mortgage rates and tariffs. The latest Housing Market Index from the National Association of Home Builders survey shows builder confidence at 32, down one point from July. Builder sentiment has now been in negative territory for 16 consecutive months.

As buyers wait for lower rates, builders continue to cut prices to incentivize sales. The latest data shows 37 percent of builders cut prices in August, down one point from July but still above the monthly average since the survey began tracking price cuts on a monthly basis in 2022. The average price cut was 5 percent in August, the same level seen every month since November 2024. The portion of builders using sales incentives to entice buyers was 66 percent, up from 62 percent in July.

Housing starts edge up as building permits decline: The latest housing starts data from the U.S. Census Bureau shows residential starts rose 5.2 percent in July to a seasonally adjusted annualized rate of 1.428 million. July’s seasonally adjusted pace is the highest in five months. However, on a year-over-year basis, starts were down 5.7 percent. Single-family housing starts rose 2.8 percent from June’s revised pace to a seasonally adjusted annualized rate of 939,000 units.

The data also suggests that construction may soon begin to tail off. Total building permits, a leading indicator of future building activity, fell 2.8 percent from June to 1.354 million. Single-family permits increased 0.5 percent to 866,000, but multi-family permits decreased 9.9 percent to 430,000.

New and continuing jobless claims rise: The number of new jobless claims rose to 235,000, an increase of 11,000 from last week’s unrevised level. That figure falls within the range of roughly 210,000 to 250,000 seen over most of the past year, indicating that employers are not laying off workers on a broad scale.

Continuing claims—the number of people who received benefits after their initial week of aid—rose slightly to 1.972 million, up 30,000 from the previous week’s revised level and the highest number of continuing claims since November 2021. The data suggests that hiring remains sluggish, keeping many workers on the sidelines as they search for jobs.

The week ahead

Tuesday: The Conference Board will release the Consumer Confidence report for August in the morning. Last month, consumer confidence rose slightly, although it remains relatively low. As the Fed continues to watch the employment picture, we’ll continue to focus on the labor market differential, which is based on the difference between the number of respondents who believe jobs are easy to find and those who report challenges in finding work. In July, the labor differential declined for the seventh consecutive month.

Data on durable goods orders for July will be released at the start of the day. We’ll be monitoring the direction of business spending against a mixed economic backdrop.

Thursday: The Bureau of Economic Advisors will release its second estimate of gross domestic product (GDP) growth for the second quarter. The first estimate showed that GDP grew at a 3 percent rate, inflated by a steep decline in imports as expected tariffs pulled forward demand. We’ll be watching for any significant revisions to the first estimate.

Initial and continuing jobless claims will be out before the market opens. Continuing claims have risen steadily of late, while initial claims have hovered around the same number. We’ll continue to monitor this report for signs of changes in the strength of the employment picture.

Friday: The July Personal Consumption Expenditures Price Index from the Bureau of Economic Analysis will be out in the morning. This is the preferred measure of inflation used by the Federal Reserve when making interest rate decisions. Inflation readings have ticked up recently, as have the price of goods. We’ll be watching to see if these trends continue.

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