The Federal Reserve enters next week’s policy meeting with markets already making up their minds. After August’s dismal jobs report, futures markets are pricing in a 100% chance of a 25-basis-point cut and even an 11% probability of a deeper 50-basis-point move. The challenge for policymakers is that while growth is flashing red, inflation risks are beginning to stir once again. The Fed faces a difficult balancing act, and the decisions made in the coming weeks could shape both policy and market sentiment into year-end.
Growth Weakness Meets Policy Certainty
The labor market has cooled with remarkable speed. August payrolls added just 22,000 jobs, far short of the 76,500 expected, while the unemployment rate climbed to 4.3%, the highest level in nearly four years. Revisions added to the bleakness: June was marked down to a net job loss of 13,000, the first monthly decline since the pandemic recovery. Markets have responded decisively. CME FedWatch shows investors pricing in a 100% chance for the Federal Reserve to cut rates next week, with even a small chance of a 50 basis point cut.
Source: Federal Reserve Bank of St. Louis (FRED), CME Group as of September 8, 2025
Tariffs Complicate the Inflation Picture
If the growth side of the mandate is pushing the Fed to cut, inflation is tugging in the opposite direction. Recent research estimates that 61–80% of the 2025 tariff package has already passed through to core goods prices, pushing those prices 1.9% above trend by June. A Federal Reserve staff note calculated that tariffs have added roughly 0.3 percentage points to core goods PCE and 0.08 percentage points to overall core PCE in just a few months.
The latest CPI report already reflected those pressures. Core CPI rose above 3% in July, the highest in six months, with economists warning of more tariff-driven upside ahead. By the time this piece is published Thursday morning, a fresh CPI reading will be released. That number may sharpen or soften the inflation debate, but the Fed’s dilemma is already clear either way.
Source: Trading Economics as of July 31, 2025
Cuts as a Market Catalyst
Small caps have been the clearest winners from shifting policy expectations. In August, the Russell 2000 surged 7%, compared to a 1.91% gain for the S&P 500 (Reuters). That 500+ basis-point spread highlights how quickly small caps can react when the policy outlook shifts. Positioning suggests there could be more to come, with net speculative positions against the Russell 2000 still deeply negative. If momentum continues, that heavy short base could fuel a squeeze, pushing the index higher at an accelerated pace.
Other areas may also benefit from easier policy. Homebuilders and housing-related equities often rally as mortgage rates decline. High yield bonds typically gain support from improved liquidity when the Fed cuts, though with spreads already below 300 basis points, broad-based compression looks limited. This can put a premium on tactical flexibility and selectivity rather than indiscriminate exposure. Gold and real assets stand to gain from lower real yields. And the weaker dollar, which has fallen alongside rising cut expectations, provides a tailwind for US exporters, commodities, and emerging market debt.
Conclusion: One Lever, Two Problems
The Fed enters next week’s meeting with little suspense over the immediate outcome, a cut is virtually certain. But the bigger story is what comes after. If the labor market continues to soften, more easing may be required. If tariffs and CPI keep firming, inflation fears will re-emerge. The Fed cannot cut for growth and raise for inflation at the same time.
For investors, the implications are straightforward. Rate-sensitive categories such as small caps, housing, high yield credit, gold, and real assets appear best positioned to benefit if easing proceeds, while stagflation risks remain on the horizon. More than the size of next week’s cut, markets may ultimately focus on how the Fed frames its outlook for the balance of 2025.
