Encouraging Data, but Caveats Remain

Last week, the US economic data painted a mixed but generally encouraging picture. Inflation showed signs of easing, consumer confidence rebounded for the first time this year, and the labor market remained relatively stable, with unemployment holding steady at a healthy 4.2%. However, a recent small uptick in continuing jobless claims hints at some cooling in the labor market.

Overall, this macro backdrop would seem to pave the way for the Federal Reserve to move towards a more accommodative monetary policy. But Wall Street watchers caution that policymakers may need more convincing evidence before cutting interest rates.

Officials Express Caution

Former Cleveland Fed President Loretta Mester said last week: “We really don’t know how the second half is going to play out.” She added that while recent “hard economic data” such as labor and inflation reports were encouraging, “the real question is what happens in the second half, and whether these trends persist. That’s where we still have a high degree of uncertainty.”

Trade Policy Uncertainty Looms

At the heart of this uncertainty lies the scope and scale of the tariff policy announced by President Trump back in April. While many of these tit-for-tat tariffs have been suspended, a benchmark 10% tariff on most countries remains in effect. The U.S. president is expected to inform his trade partners in the coming weeks of their respective unilateral tariff rates.

Meanwhile, Mexico and Canada continue to face fentanyl-related tariffs, while tariffs on specific industries such as steel, aluminum, and autos remain unchanged.

The Fed in Wait-and-See Mode

Mester says: “The Fed will stand pat until we have a clearer understanding of the size and breadth of the tariffs, and their impact on inflation, and how tariffs and other policies, including budget bills, are going to affect growth and employment.”

Despite these cautious pronouncements, market confidence in an impending rate cut is growing. According to CME Group’s FedWatch Tool, as of Monday morning, nearly 70% of investors are betting that the Fed will begin cutting interest rates in September, up from 60% a week earlier. Investors see about a 20% chance of the first rate cut coming as early as July.

Still, the market has almost fully priced in expectations that the Fed will hold interest rates steady at its policy meeting next week.

Inflation Concerns Persist

Brent Schutte, chief investment strategist at Northwestern Mutual Wealth Management, warns that any rate cut before September would likely require a significant deterioration in the labor market. He also cautioned that the inflation threat has not disappeared, especially with the uncertain impact of tariffs.

“People are implying that tariffs may not have an inflationary impact. I think it’s too early to make that determination now,” Schutte said. “All the inventory that importers, consumers, and businesses front-loaded in response to tariffs may be influencing the current inflation data. In the past, it typically takes a while for that to show up in the actual numbers.”

He concludes that the Fed is in a “wait-and-see period.” “That’s why I think the Fed may not cut rates until September unless you see significant weakness in the labor market, and then the question will be: Is it too late to cut?”

HSBC U.S. economist Ryan Wang acknowledges the tariffs pose a “double-edged risk,” noting that while goods prices may continue to rise for the remainder of the year, initial signs of labor market cooling could partially offset this impact by exerting downward pressure on inflation.

While the market may be betting on the Fed embarking on a smooth path of rate cuts, Wang cautions that the Fed needs to be convinced that inflation is not experiencing a “runaway” surge and that overall economic activity is not decelerating too quickly. He says: “A benign version of rate cuts takes time to develop.”

For now, the Fed appears firmly in wait-and-see mode: acknowledging the encouraging data but not yet convinced it's time to change course.