SF FedViews: September 4, 2025

The U.S. economy is exhibiting a softening labor market, with recent job growth significantly slowing and substantial downward revisions to prior months' data, though the unemployment rate remains low at 4.2%. Inflation persists above the Fed's 2% target, with July PCE at 2.6% and Core PCE at 2.9%, and is expected to rise further due to tariff-driven price increases. Despite volatile H1 2025 GDP growth influenced by net export swings, financial markets are increasingly projecting an easing of monetary policy in the coming months, reflecting a perceived shift in the Federal Reserve's balance of risks.

Analysis

The U.S. economy is navigating a complex environment characterized by resilient but softening activity, persistent inflation, and shifting monetary policy expectations. Recent labor market data indicates a clear slowdown, with July job gains at a mere 73,000 and significant downward revisions of 258,000 for the prior two months, pushing the six-month average down to 81,000. While the unemployment rate remains low at 4.2%, the trend of initial job reports overstating growth, confirmed by subsequent reliable revisions, points to a definitive cooling. Concurrently, inflation remains stubbornly above the Federal Reserve's target, with July's PCE and Core PCE inflation at 2.6% and 2.9% respectively, suggesting the disinflationary trend has stalled. This is further complicated by the expectation that upcoming tariffs will exert upward pressure on prices. Economic growth in the first half of 2025 was volatile, distorted by tariff-related swings in net exports, which clouds the underlying momentum. Despite the sticky inflation, financial markets are increasingly pricing in monetary policy easing in the coming months, indicating a belief that the Fed's focus will shift from inflation to addressing the softening labor market.

Key Decisions for Investors

• Investors should closely monitor upcoming PCE inflation data and trade policy announcements, as the expected tariff-driven price increases could delay or reverse the market's priced-in monetary easing.
• Given the established pattern of initial job reports overstating growth, it is prudent to place greater weight on the two-month subsequent revisions to gain a more accurate assessment of the labor market's trajectory, rather than reacting to potentially misleading headline numbers.
• The growing divergence between dovish market expectations for rate cuts and the Federal Reserve's challenge with persistent, above-target inflation presents a key risk; investors should be prepared for potential volatility in fixed income and equity markets if the Fed's actions do not align with these expectations.