Economy and financial markets at a crossroads Economy and financial markets at a crossroads http://www.federatedhermes.com/us/static/images/fhi/fed-hermes-logo-amp.png http://www.federatedhermes.com/us/daf\images\insights\article\cross-roads-small.jpg September 12 2025 September 12 2025

Economy and financial markets at a crossroads

The Federal Reserve is poised to relaunch its rate-cutting cycle.
Published September 12 2025
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Investors find themselves at a junction. Corporate revenues and earnings have been better than expected over the past two quarters, and estimates are moving higher for the balance of this and next year. Consumer spending has been strong, particularly at the high-end, and the holiday season should be solid. Business and consumer confidence has rebounded since plummeting in the immediate aftermath of President Trump’s Liberation Day tariff fiasco. Lastly, manufacturing activity has begun to percolate.

Follow the money Consequently, stocks and bonds have soared over the last five months. The S&P 500 has surged 36% to a new intraday record high of 6,600 today, surpassing our full-year 2025 target of 6,500. Meanwhile, benchmark 10-year Treasuries rallied from 4.60% to a five-month low of 4.00% yesterday, eclipsing our year-end target yield of 4.10%.

Bumps in the road? All is not sunshine and roses, however. The labor market has weakened considerably in recent months, with sizable downward revisions over the past two years. Although inflation has declined sharply from 40-year highs in 2022, critics contend that Trump’s tariff and immigration policies will soon spark a resurgence. The housing market has been brutal, with high mortgage rates, low inventory and record-high home prices collectively resulting in the worst affordability in 40 years.

Dual mandate conundrum Despite the drama surrounding its independence, the Federal Reserve is on the cusp of launching an interest-rate cutting cycle next week, which we believe will include six quarter-point cuts over the next 18 months, taking the upper band of the fed funds rate down from 4.5% now to 3.0% by year-end 2026. As the Fed weighs conflicting data in its Phillips Curve tradeoff, it must orchestrate a delicate balancing act, as policymakers seem to believe that the rapid deterioration in the US employment situation is more important than the recent moderate increase in inflation.

Labor market stress Over the past four months, nonfarm payroll gains have averaged only 27,000 jobs per month, the weakest pace of job creation since the depths of the Covid pandemic. That compares poorly with the average monthly payroll gains of 123,000 over the first four months of the year and 168,000 over 2024. This past Tuesday, the Labor Department released its Quarterly Census of Employment and Wages, which measured the 12-month period through the end of March 2025. The report revised job creation down by a considerable, worse-than-expected 911,000 jobs, even more than the negative revision of 818,000 last year. Yesterday, initial weekly jobless claims, a high-frequency leading indicator, surged to a nearly four-year high of 263,000 for the week ended September 6.

Whither inflation? Inflation is down sharply over the past three years, but it has ticked up in recent months, likely due to tariffs. Core PPI wholesale inflation, which peaked at a record 9.7% year-over-year (y/y) in March 2022, declined to a one-year low of 2.6% y/y in June 2025, and inched up to 2.8% in August. Core CPI retail inflation, which surged to a 40-year high of 6.6% y/y in September 2022, slowed to a four-year low of 2.8% y/y in March, April and May, and rose to 3.1% in July and August. Core PCE inflation (the Fed’s preferred metric), which soared to a 39-year high of 5.6% y/y in February 2022, declined to a four-year low of 2.6% in April 2025. July rose to 2.9% y/y, a level that is expected to remain steady in August. The Fed believes that the impact on inflation from higher tariffs is likely to be a one-time adjustment, which provides the Fed with the air cover it needs to cut rates to support the rapid deterioration in the labor market.

Volatility on the horizon? Stocks and bonds appear modestly overbought now, in the wake of their powerful rallies over the past five months. We’re also in the midst of what is historically the most challenging seasonal period of the year. In addition, over the past 35 years spanning five Fed rate-cutting cycles, when the central bank began to reduce interest rates, the S&P 500 corrected by an average of 8-9%. So, we could be in a “Buy the Rumor, Sell the News” environment, in which financial markets have soared on the prospect of Fed rate cuts. But the commencement of those cuts could focus the market’s attention not just on the rate cut, but why the Fed is cutting rates, which is the rapid decline in the labor market. We’re a buyer on any near-term dips, which we believe would set the market up for a year-end rally to our 2026 full-year target of 7,500.

Raising our forecasts The equity, fixed income and liquidity investment professionals who comprise Federated Hermes’s macroeconomic policy committee met on Wednesday to discuss the state of the economy, fiscal and monetary policy in Washington, and financial market performance. The Commerce Dept. revised second quarter 2025 GDP up from a gain of 3.1% to 3.3%, compared with a decline of 0.5% in the first quarter, largely due to stronger personal consumption and corporate spending. Core private domestic final sales were revised up from a 1.2% gain to 1.9% in the second quarter.

  • We increased our estimate for third quarter 2025 GDP growth from 2.3% to 2.5%, while the Blue-Chip increased its estimate from 0.5% to 0.9% (within a range of -0.2% to 1.8%). Corporate capex spending is accelerating after the OBBB was signed into law in July, and Back-to-School spending has been stronger than expected. The Atlanta Fed raised its GDPNow estimate from 2.3% to 3.0%.
  • We left our forecast for fourth quarter 2025 growth unchanged at 2.5%, while the Blue-Chip consensus also left its estimate unchanged at 0.8% (within a range of -0.8% to 1.8%). We’re expecting solid holiday spending driven by the wealth effect. 
  • As a result, we raised our full-year 2025 growth estimate from 1.8% to 2.0%, while the Blue-Chip consensus also raised its estimate from 1.4% to 1.6% (within a range of 1.2% to 1.8%). 
  • Inflation has risen moderately over the last several months, as tariffs have begun to filter their way through the economy. So, we increased our year-end 2025 forecast for core CPI inflation from 2.9% to 3.0% (compared with actual core inflation of 3.1% in July and August 2025), while the Blue Chip lowered its estimate from 3.0% to 2.8% (within a range of 2.7% to 3.1%). We also raised our year-end 2025 estimate for core PCE inflation from 2.7% to 2.8% (compared with actual core inflation of 2.9% in July 2025), while the Blue-Chip consensus left its estimate unchanged at 2.8% (within a range of 2.6% to 3.0%).
  • Given the prospect of lower interest rates and stimulus from the One Big Beautiful Bill, we initiated our forecast for first quarter 2026 GDP growth at 2.8%, while the Blue-Chip consensus is at 1.4% (within a range of 0.2% to 2.3%). 
  • We initiated our forecast for second quarter 2026 growth at 2.9%, while the Blue-Chip consensus is at 1.8% (within a range of 0.8% to 2.6%). 
  • We initiated our forecast for third quarter 2026 growth at 3.0%, while the Blue-Chip consensus is at 1.9% (within a range of 1.3% to 2.5%). 
  • We similarly initiated our forecast for fourth quarter 2026 growth at 3.0%, while the Blue-Chip consensus is also at 1.9% (within a range of 1.3% to 2.6%). 
  • We left our estimate for full-year 2026 GDP growth unchanged at 2.8%, while the Blue Chip increased its estimate from 1.4% to 1.5% (within a range of 0.7% to 2.1%). 
  • We increased our year-end 2026 estimate for core CPI inflation from 2.6% to 2.7%, while the Blue Chip reduced its forecast from 2.9% to 2.8% (within a range of 2.4% to 3.5%). We also raised our year-end 2026 estimate for core PCE inflation from 2.3% to 2.4%, while the Blue Chip left its estimate unchanged at 2.8% (within a range of 2.3% to 3.4%).

Read more about our current views and positioning at Capital Markets.

Connect with Phil on LinkedIn

Tags Markets/Economy . Monetary Policy . Equity .
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DISCLOSURES

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

Phillips curve: An economic model that portrays an inverse relationship between the level of unemployment and inflation on an historical basis but has come under doubt in recent decades. 

Consumer Price Index (CPI): A measure of inflation at the retail level.

The National Association of Home Builders/Wells Fargo Housing Market Index is a gauge of how well or poorly builders believe their business will do in coming months.

Personal Consumption Expenditures Price Index (PCE): A measure of consumer inflation at the retail level that takes into account changes in consumption patterns due to price changes.

Producer Price Index (PPI): A measure of inflation at the wholesale level.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

Stocks are subject to risks and fluctuate in value.

The value of investments and income from them may go down as well as up, and you may not get back the original amount invested. Past performance is not a reliable indicator of future results. 

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