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Inflation remains sticky, but a pathway to a rate cut is emerging

Financial markets are currently anticipating no interest rate cuts by the Federal Reserve this year. In fact, expectations have shifted dramatically, with markets now pricing in the next rate cut as late as June 2027, compared to expectations of three cuts at the beginning of this year.

While financial markets are not pricing in a cut until next year, the Fed should, and likely will, reduce rates this year.

The Federal Reserve operates under a Congressionally mandated dual mandate: to promote stable employment and low inflation. The current policy framework targets an inflation rate of 2%.

One of the challenges with the dual mandate is that these objectives can come into conflict. Strong employment growth, for example, can generate upward pressure on inflation, prompting the Fed to raise interest rates to slow the economy and bring inflation back toward its target.

Conversely, weak employment growth is often associated with lower inflation, typically during or near recessionary periods. In that case, the Fed will place greater emphasis on supporting employment.

In both scenarios, rate cuts are used to stimulate economic activity, while rate increases act as a brake to cool growth and inflation.

While the Fed remains focused on inflation, it is past time to shift greater emphasis toward the employment side of the mandate. Current labor market conditions justify a rate cut, not in June 2027, but sooner, potentially at one of the upcoming meetings.

Start with employment growth. Over 2025, job gains averaged just 15,000 per month, making it one of the weakest years of employment growth in more than two decades outside of recessionary periods. Importantly, much of that growth has been concentrated in health care. Excluding that sector, overall employment growth would be flat to negative, hardly indicative of a stable labor market.

Last month’s employment report came in stronger than expected, but the underlying details were less encouraging. Health care again accounted for a significant share of job gains, while the labor force participation rate declined and overall labor force growth softened.

Unemployment claims remain low, but hiring activity has slowed considerably. Employers are holding back. A rate cut would help stimulate demand and encourage firms to expand hiring.

On the inflation side, headline measures continue to run above the Fed’s 2% target. Recent increases in the Consumer Price Index (CPI) were influenced in part by higher energy prices, driven by geopolitical tensions and a temporary spike in oil prices.

The Fed, however, focuses more closely on core inflation, which excludes food and energy. Core CPI has been more subdued, rising 2.6% over the past year. On a monthly basis, recent increases suggest inflation is running closer to a 2.4% annualized pace, still above target, but moving in the right direction.

The Fed’s preferred measure, the Personal Consumption Expenditures (PCE) price index, remains somewhat elevated. Core PCE increased 0.4% last month and is running near 3% year-over-year. While still above target, there are reasons to expect moderation in the months ahead.

Concerns about stagflation, a combination of slower growth and persistent inflation, remain valid. However, with geopolitical pressures potentially easing and oil prices stabilizing, headline inflation should begin to move lower.

In this environment, the “stag” is likely to outweigh the “flation.” Slowing employment growth will push the Fed toward a more accommodative stance.

At the same time, gains in productivity, driven by technological investment and artificial intelligence, may help ease inflationary pressures, giving the Fed additional room to cut rates without reigniting inflation.

The Fed does not need to wait until 2027. The conditions for a rate cut are beginning to fall into place, and the window for action is opening sooner rather than later.