Interest rates

Inflation or employment? The Fed makes its choice

Tom Hollenberg Jared Franz Charles E. Ellwein Jody Jonsson

September 18, 2025

The scales have tipped in the U.S. Federal Reserve’s long running balancing act between taming inflation and promoting full employment. With Wednesday’s quarter-point interest rate cut, the first such move in nine months, Fed officials appear to have made the labor market a key concern.

 

Despite signs of rising inflation, the Fed reduced its key policy rate following a series of weak job reports and growing concerns that many companies aren’t hiring amid the economic uncertainty posed by tariffs and trade disputes.

 

“Going forward, I do think the labor market is going to get more of the Fed’s attention than inflation,” says Tom Hollenberg, fixed income portfolio manager. “I think the Fed is basically expressing the view that tariff-related inflation is a one-off, and that clears the ground for a rate cut now, as well as additional cuts later this year.

 

“For better or worse, we are at the start of another rate-cutting cycle,” Hollenberg adds. “It may ultimately be 50 to 75 basis points, or it may be more. The Fed has put inflation on the back burner, and I think that matters.”

Fed seeks to balance dual mandate

Sources: Capital Group, LSEG, Bureau of Economic Analysis, Bureau of Labor Statistics, Federal Reserve. Inflation measured by year-over-year change in the U.S. Core Personal Consumption Expenditures Price (PCE) Index. Median long-run full employment target sourced from June 18, 2025, Federal Open Market Committee (FOMC) economic projections. Core PCE latest data available is through July 2025 as of September 11, 2025. U.S. unemployment rate latest data available is through August 2025 as of September 11, 2025.

The Fed’s decision comes at a time of conflicting economic crosswinds and renewed concerns about Fed independence as President Trump implores the central bank to lower interest rates. Year-over-year core PCE inflation is likely to come in at 2.9% in August, the highest level since February. Meanwhile, the August jobs report showed that hiring has essentially stalled, with just 22,000 new jobs added. The U.S. unemployment rate has creeped up to 4.3% from a 50-year low of 3.4% in April 2023.

U.S. economic outlook weakens

The U.S. economy has remained resilient so far this year despite worries that higher tariffs might trigger a recession. No such downturn has materialized yet. U.S. GDP growth rose 3.3% in the second quarter, but signs of weakness are spreading, according to Capital Group economist Jared Franz.

 

“In my view, the U.S. economy is entering a mini-cycle slowdown,” Franz says. “Hiring may stall across multiple sectors, but not enough for the unemployment rate to rise to levels commonly associated with a recession.”

 

The Fed’s focus on jobs is understandable since consumer spending accounts for roughly two-thirds of the U.S. economy. More recently, massive AI spending by U.S. tech companies has provided a significant boost to economic growth.

 

In addition, tighter U.S. immigration policy has influenced labor markets. Immigration enforcement has reduced the overall number of workers in the economy, contributing to relatively stable unemployment levels this year, even as hiring has drastically slowed.

 

With Wednesday’s rate cut, the U.S. federal funds rate now sits in a range from 4% to 4.25%. It influences interest rates on many other forms of borrowing, including cash, U.S. Treasury bill yields, home mortgages and credit cards.

Falling rates could support growth

Sources: Capital Group, Bloomberg Index Services Ltd., U.S. Federal Reserve. Fed funds target rate reflects the upper bound of the Federal Open Market Committee's (FOMC) target range for overnight lending among U.S. banks. Projections are based on the pricing of monthly fed funds futures contracts as derived from Bloomberg. As of September 17, 2025.

Rate cuts could further boost U.S. markets

After a period of tariff-related volatility earlier this year, the S&P 500 Index has hit a series of new highs, driven largely by healthy corporate earnings and investor enthusiasm for artificial intelligence. But gains have been uneven, with sectors such as health care and industrials lagging U.S. tech, particularly AI-related stocks.

 

Stock and bond markets have notched solid returns in non-recessionary rate-cutting cycles, as depicted in the table. On average, the S&P 500 Index has returned nearly 28% in the three non-recessionary cutting cycles since 1984. U.S. bonds too have benefited, seeing a nearly 17% annualized return, while cash has lagged.

Staying the course throughout the cycle 

Sources: Capital Group, Bloomberg Index Services Ltd., Morningstar, Standard & Poor’s. Return calculations reflect annualized total returns over periods in which the U.S. Federal Reserve had stopped raising rates and began to actively cut rates, measured from the peak federal funds rate target to the lowest federal funds rate target for each cycle. Specific easing cycles include August 1984 to August 1986 (non-recessionary), May 1989 to September 1992 (recessionary), February 1995 to January 1996 (non-recessionary), March 1997 to November 1998 (non-recessionary), May 2000 to June 2003 (recessionary), June 2006 to December 2008 (recessionary), and December 2018 to March 2020 (recessionary). Benchmarks used are the S&P 500 Index (U.S. stocks), MSCI World ex USA Index (international stocks), Bloomberg U.S. Aggregate Index (U.S. bonds), and the average investment rate of 3-month U.S. Treasury Bills (cash). As of December 31, 2024.

However, tariff uncertainty and its impact on global supply chains continues to influence company decisions and could influence market sentiment in the months ahead, says Charles Ellwein, equity portfolio manager for American Mutual Fund®.

 

“In my conversations with large U.S. companies, tariffs have led their customers to delay orders,” Ellwein explains. “The uneven rollout, changing tariff rates and court challenges to the legality of U.S. tariffs have complicated the picture. Trading partners want to know how tariffs are being passed along to them, and they are seeking ways to claw back those costs if the tariffs are ultimately overturned.”

Maintaining a balanced porfolio 

The ongoing uncertainty around global trade policy, inflation, employment, economic growth and other market forces provides a reminder of why it’s important for investors to maintain a diversified, well-balanced portfolio constructed to help it buffer market shocks.

 

“Inflation and Fed independence are issues that I am particularly concerned about and watching closely,” says Jody Jonsson, Capital Group Vice Chair and a portfolio manager with New Perspective Fund®. “U.S. equity valuations are at very high levels right now, so an inflationary shock or a crisis at the Fed would probably not be well received by investors.”

 

“I remain fully invested,” Jonsson adds, “but I am coupling growth-oriented companies with more defensive names. I think it’s always important to keep that balance. Defensive companies are generally lagging the overall market today, but I think there will be a moment when investors will be happy to have them in their portfolios.”

Read important disclosures

TOMH

Tom Hollenberg is a fixed income portfolio manager with 20 years of industry experience (as of 12/31/2024). As a fixed income investment analyst, he covers interest rates and options. He holds an MBA in finance from MIT and a bachelor's degree from Boston College.

JASF

Jared Franz is an economist with 19 years of investment industry experience (as of 12/31/2024). He holds a PhD in economics from the University of Illinois at Chicago and a bachelor’s degree in mathematics from Northwestern University.

Charles E. Ellwein

Charles Ellwein is an equity portfolio manager with 27 years of investment industry experience (as of 12/31/2024). He holds an MBA from Stanford and a bachelor’s degree in electrical engineering from Brown University.

jody-johnson-color-600x600new

Jody Jonsson is vice chair of Capital Group, president of Capital Research and Management Company and an equity portfolio manager. She has 38 years of investment industry experience (as of 12/31/2024). She holds an MBA from Stanford and a bachelor’s degree in economics from Princeton.

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Past results are not predictive of results in future periods.

 

The U.S. Core Personal Consumption Expenditures Price Index (PCE) provides a measure of the prices paid by people for domestic purchases of goods and services, excluding the prices of food and energy. The core PCE is the Fed's preferred inflation measure.

 

The Federal Reserve seeks to achieve inflation at the rate of 2% over the longer run as measured by the annual change in the price index for PCE.

 

The market indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index.

 

Bloomberg U.S. Aggregate Index represents the U.S. investment-grade fixed-rate bond market.

 

MSCI World ex USA Index is designed to measure equity market results of developed markets. The index consists of more than 20 developed market country indexes, excluding the United States.

 

S&P 500 Index is a market capitalization-weighted index based on the results of approximately 500 widely held common stocks.

 

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