BY: Jim McElroy
May You Live in Interesting Times
Here we are, two-thirds of the way through 2025, at the beginning of fall (just past the autumnal equinox) and the Federal Reserve has cut overnight rates by .25% (from a range of 4.25%-4.5% to a new range of 4.00%-4.25%). This is the first change in rates in nine months, and it was much anticipated. However, for those of us with short attention spans, the characterization of this action as the fourth continuation of an easing cycle, which began in September of 2024, seems surprising. And, in fact, the stretch of nine months from the end of December 2024 through September 2025 is the longest “pause” of easing in seventy-one years (the available history only goes back seventy-one years). We’re accustomed to the Fed lowering or raising rates to a desired level and then maintaining that level until a reversal becomes necessary. But the continuation of an easing cycle after a nine-month hiatus is unusual and suggests a certain uniqueness in current economic conditions.
A brief history of Federal Reserve action over the last five or six years reveals how especially difficult its job has become. Managing overnight interest rates to encourage employment and discourage inflation has always been difficult, but the period since the beginning of the current decade includes a global pandemic and the disruptive early days of Trump’s second term. We live in interesting times!
In April 2020, with the nation in full pandemic/panic mode, the Fed cut overnight rates to essentially zero, with the hope of minimizing a recession and preventing a much more debilitating depression. After keeping overnight rates at near zero for two years — another seventy-one- year record — it voted in March 2022 to begin raising rates to minimize an expected post- pandemic acceleration in inflation (indeed, from March 2021 through June 2022, the annualized monthly Core PCE — the Fed’s preferred measure of inflation — exceeded 7% three times). From near zero in March 2022 through August 2023, the Fed steadily lifted overnight rates, halting at a range of between 5.25% and 5.5%. It maintained this range until August 2024 when Core PCE inflation appeared to be moving in the direction of the Fed’s 2% target, but at the price of an unemployment rate increasing to a worrisome level. At this point, the Fed initiated a three-step easing regimen, from September through December 2024, that brought overnight rates down to a range of 4.25% to 4.5%, for a total easing of 1%. The Fed then paused, likely to judge the results of its actions, but also to weigh the effects of higher levels of uncertainty attached to a new administration in Washington.
The election of a new president is always a source of uncertainty for markets and businesses. However, the return of Donald Trump to the White House at the beginning of 2025 produced a higher-than-normal uncertainty because of his inclination to disrupt rather than follow established political norms. President Trump’s imposition of tariffs on trade at a level not seen since the Great Depression, his massive employee reductions in executive branch departments — including the Bureau of Labor Statistics, the source for most of the statistics on employment health — and his attempts to diminish the independence of the Federal Reserve in setting short-term interest rates, all may well have influenced the length of the Fed’s pause. The uncertain impact of tariffs on consumer inflation and the skepticism over employment numbers compiled by a depleted Bureau of Labor Statistics should give pause to anyone.
During this pause, employment statistics (such as they were) weakened. Nonfarm payrolls increased a disappointing 22,000 in August, and the June payroll number was revised downward from a positive 147,000 to a negative 13,000, the first negative reading since December of 2020. Initial jobless claims remained below the level considered healthy for the labor market, and the unemployment rate increased, albeit slowly, for all of 2024, and for the nine months of 2025.
The rate of inflation (Core PCE) during the pause did moderate from the scarcity days of the pandemic, but remained stubbornly above the Fed’s 2% target: annualized monthly Core PCE inflation for the last eight months (September not available) registered a high of 5.51% in February, a low of 1.18% in March, and an average of 3.05%. Since the Fed put a period to its pause by cutting overnight rates by .25%, it likely considers the possibility of a job ending recession to be a greater risk to the economy than higher inflation. And we shouldn’t ignore the extraordinary pressure that the executive branch placed on the Fed to reduce rates: it may not have driven the decision to ease, but it certainly made it more difficult not to do so.
Of course, during the nine months pause (from 12/19/24 to 9/17/25), the market enthusiastically cheered the likelihood of a continuation of rate reductions by adding 12.5% to the S&P 500. Subsequent to the .25% cut, the S&P 500 made further gains, finishing the third quarter with a positive 7.8% and the first three quarters of 2025 with a positive 13.7%. The market is anticipating more rate cuts before the end of the year — the hearsay consensus is for two .25% cuts — and likely more in 2026. We think that these expectations are aggressive and perhaps unrealistic, given some of the current pressures on inflation.
The prospects for inflation are not what the Fed would wish under the regimen of a 2% target. For example, it’s difficult to imagine that Trump’s higher tariffs on imported goods will not engender higher prices for consumers. Some argue that tariffs create only one-time price increases — an increase for one year and then leveling prices thereafter — but that’s assuming companies won’t spread price increases over multiple time periods or, as Fed Chairman Powell warns, “A ‘one-time’ increase does not mean ‘all at once’”. Another worrisome dynamic for inflation is the shrinking of the supply of labor due to more restrictive immigration requirements: fewer workers mean higher wages, higher labor costs, and higher consumer prices. If the Fed’s concern for inflation increases and it cuts rates only once more before the end of the year, or if it signals few or no cuts in 2026, we would expect the equity markets to respond negatively: a correction (down 10%) would not be out of the question, given the current rather exalted valuations on stocks: the P/E ratio on the S&P 500 is 25 times forward earnings (the 35-year average is only16).
There is, however, another factor besides anticipated Fed cuts that may be responsible for high multiples of earnings: there is great enthusiasm surrounding the development of artificial intelligence and its vaunted promise of revolutionary improvements in economic efficiencies and living standards. The promise of AI in future years, if realized to the extent its most enthusiastic supporters envision, would put it on a transformational path that would exceed even Henry Ford’s moving assembly lines. This almost utopian vision for AI is currently driving massive investment spending on new data centers and power plants. It’s also driving up the market values of the companies most associated with AI, the so-called “Magnificent Seven” or “Mag 7”: Amazon, Alphabet/Google, Microsoft, Meta, Nvidia, Apple, and Tesla. Since early 2023, the stocks of these companies have been responsible for about one-third of the appreciation of the S&P 500. Although recently there has been some broadening of market participation by other sectors, industries, and companies, the Mag 7 domination of the index continues.
We do live in interesting times, a phrase commonly employed as a euphemism for periods of nerve-rattling and dangerous events. And we’ve had our share of them, and will probably have more: the mercurial nature of the administration in Washington will surely continue to surprise and bewilder us. But at least for the third quarter of 2025, equities and interest rates have been kind: the S&P 500 is up 7.8%, Fed Funds are at 4% and likely declining, the yield curve is positive beyond three years, and ten-year Treasuries at 4.2% are at least below their year-ago level of 5%. “Interesting” can be good.
Summary
- When the Fed recently cut rates by .25%, it was the fourth cut in the easing which began in the fourth quarter of 2024.
- There was a nine-month pause between the third and fourth rate cuts. It was the longest pause in 71 years.
- The Fed paused because of the stubbornness of inflation above 2% and the uncertainty surrounding the new administration in Washington.
- Tariffs are likely to be inflationary.
- High P/Es on future earnings are based on perhaps exaggerated expectations of rate cuts and extreme levels of enthusiasm about AI.
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