The Federal Reserve is expected to lower interest rates by a quarter point on Wednesday, the first move in an easing cycle prompted by a slowing labor market. Yet with inflation still running close to 3 percent, investors warn the bank may be cutting into a “stagflation-lite” backdrop: weaker growth alongside stubborn price pressures.
Headline growth in the United States does not suggest much to worry about. According to the U.S. Bureau of Economic Analysis, real GDP expanded at a 3.3 percent annual rate in the second quarter, following a 0.5 percent contraction in the first. Yet beneath the surface, momentum looks less secure: the unemployment rate is rising, job growth is slowing and inflation is picking up.
“The whiff of stagflation is getting stronger,” Jason Furman, professor of economic policy at Harvard University, wrote on X last week. “There are no good options for the Fed given these circumstances.”
His comments come as the Bureau of Labor Statistics recently cut job estimates by more than 911,000, confirming that payrolls were far weaker than previously thought. Excluding healthcare, private employment has been shrinking since April. From June to August, payrolls grew by only about 30,000 a month.
Inflation, meanwhile, has risen back to 2.9 percent from a low of 2.3 percent in April. For Joseph Little, chief market strategist at HSBC, the mix amounts to “stagflation-lite”, not the 1970s variety of runaway inflation and recession, but an uncomfortable combination of softening growth and sticky prices.
Ten-year Treasury yields have slipped, while the gap between short- and long-term rates has widened, highlighting growing concern about the economy. Equities are buoyed by expectations of Fed easing and the ongoing AI rally, but Little warns that the risk remains that a cooling labor market could give way to a sharper downturn.
Debating stagflation-lite
Chengjun Chris Wu, senior portfolio manager at Federated Hermes, agrees the term “stagflation-lite” captures today’s tension, but stresses full-blown stagflation is rare and likely to stay that way. Still, he warns tariffs could shave a full percentage point off GDP-growth while pushing prices higher, “a big tax on consumers,” as he calls it.
Wu notes that private domestic demand, a core measure of household and business spending, has slowed to about 1 percent of GDP from 2.5 percent in 2024. Business surveys also point to softer activity. Yet with unemployment steady at around 4.1 percent, he argues companies are reluctant to cut staff outright. That explains why the U.S. is not in recession despite weaker internals. “Given the slowdown, it would be a policy error for the Fed to leave rates unchanged at their next meeting,” Wu added.
Mark Dowding, chief investment officer at BlueBay, believes structural labor shifts, from slower immigration to automation, will leave job creation subdued even as output grows. “It is interesting to observe a downturn in technology jobs as these begin to be replaced by machines,” he said.
Equities look through the risks
Fortunately for Americans, today’s economic circumstances still look mild by historical standards. The Misery Index, the sum of unemployment and inflation, stands at about 7 percent. That is higher than the pre-pandemic lows but far below the 22 percent peak that scarred the U.S. economy in the 1970s.
This helps explain why equity investors remain focused on the cushion provided by monetary easing. The MSCI AC World Index trades at nearly 19 times expected earnings, a level that looks hard to sustain without lower rates.
“Interest rate cuts reduce downside risk and, together with higher government spending, increase the likelihood of a resurgence in growth in the second half of 2026,” said Anwiti Bahuguna, deputy CIO at Northern Trust Asset Management. She sees corporate earnings growth of 8 to 12 percent next year as reasonable, provided inflation does not spiral higher.
Bahuguna acknowledges risks such as a collapse in the labor market or persistent inflation, but says they are not part of her base case.
President Donald Trump is preparing to nominate a successor to Jerome Powell as Fed chair, with candidates narrowed to Kevin Warsh, Kevin Hassett and Christopher Waller. Markets expect the next chair to lean dovish and align closely with the administration.
“Delivering rate cuts may not be a problem if inflation remains benign,” Dowding said. “The situation could become much more uncomfortable, should the momentum in prices show signs of an acceleration.”
Markets are currently pricing in as much as 150 basis points of rate cuts by the end of next year.