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, a Capital Group 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.”

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.

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.

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, a Capital Group equity portfolio manager.

“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 portfolio

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. “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.”