Climbing a Wall of Comfort

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Mission Creep

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Soundbite: Equity markets celebrated the drop in the Fed Funds forecast and Chair Powell’s repositioning of his monetary policy view from “moderately restrictive” to “clearly restrictive.” However, the 2026 PCE inflation forecasts in September’s Summary of Economic Projections (SEP) shifted higher relative to June. This shift is a continuation of the creep higher seen in June relative to March. The drift away from the 2% target sees core PCE median projections moving from 2.2% to 2.6% over the last six months. Whereas the market has interpreted the central bank as more concerned about employment, ignoring any inflationary impulse, the SEP shows a bias toward higher inflation. Contrary to the consensus, there is little tolerance for any inflation uptick at the Federal Open Market Committee (FOMC). One bad inflation report risks derailing expectations for two more rate cuts this year.

Inflation is still very much front-of-mind at the FOMC.

Buried in the SEP report is the distribution of inflation forecasts across all 19 FOMC participants. In March, that distribution showed a majority of the 19 FOMC members forecast a 2.1%-2.2% annual inflation rate for year-end 2026, quite close to the Federal Reserve’s 2% target. June’s updated core PCE Price Index expectations shifted slightly higher. However, that shift became much more pronounced with the most recent inflation estimates.

The September SEP disclosed that 17 of 19 Committee members expect core PCE to come in at or above 2.5% inflation by year-end 2026. Although it is a decline from 3% current inflation levels, it highlights the difficulty for the Fed moving forward, especially if core services inflation ex-housing continues to increase as we expect it will. In addition, core goods inflation has been rising despite firms barely passing through tariffs.

We wrote in our “New Face in the Fed, New Face of the Fed” Substack hours before the FOMC that if the September statement did not remove “The Committee is attentive to both sides of its dual mandate,” it would signal “the majority of the Committee was still very concerned about inflation.” The dual mandate wording was untouched, although they added the phrase “downside risks to employment have risen.” The SEP contains a compilation of each FOMC member’s assessment of the uncertainty and risks to inflation forecasts. It clearly shows that the vast majority of the FOMC are equally concerned with both the upside risk to inflation and unemployment.

Investors are comfortable with the expectation of two more rate cuts this year and three the next. The reality, however, is that monetary policy is sensitive to any increase in inflation. The chances of a negative surprise have risen, despite the absence of any worry among investors.

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Out of the Question

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Soundbite: Four words is all it takes. Raphael Bostic penned his latest quarterly letter just before the September Fed meeting. In it, the president of Atlanta Federal Reserve Bank put it simply: If the Fed were operating under a sole mandate of price stability (as many other central banks do), then “lowering the federal funds rate in this environment would be out of the question.” Bostic made a clear case as to why he thought the Fed should cut in September, and why that cut should be the last one this year. Yes, employment is weakening, but it has basically caught up to the level of concern about inflation. This fact supports our message in the above first Point that inflation has not been forgotten by the Fed, although it has been by the market.

Raphael Bostic’s letter served as a manifesto for a continued measured approach to monetary policy, providing an insider’s view of the landscape within the FOMC. He was far from an outlier, as he is one of no fewer than seven (out of nineteen FOMC members) forecasting no more rate cuts in 2025. He summed his position up as follows:

“Unlike most of the past several years, when risks to the inflation mandate were clearly the greater risk, risks to the employment mandate have increased such that…the risks to the two mandated goals are…coming closer to balanced.”

This viewpoint is an important contrast to investors who have priced in five more cuts into 2026 based on fears about weaker employment; he underlined the fact that the reduced labor supply keeps the labor market tight. As Bostic succinctly put it, “we are still close to the Committee’s maximum employment objective.”

He went on to argue that services prices are persistently high, and goods prices are rising. President Bostic argues that tariffs could keep inflation rising for months. An analysis by the Atlanta Fed economists found that tariffs are increasing costs to companies that are absorbing them, but “may not have the capacity to eat higher costs much longer.” What concerns Bostic is that It's not just firms directly affected by tariffs…but the spillover onto firms that are not exposed to tariffs…raising the risk of a broad-based increase in inflation," He concluded that the full effect of tariffs will not be seen for months, and “a broadening of overall price pressures…[similar to the]…pandemic-era inflationary impulse” is his base case.

Bostic’s concluding remarks on the Fed’s latest strategic framework review are salient: “the revised framework emphasizes our commitment to 'act forcefully to ensure that longer-term inflation expectations remain well anchored, to the benefit of both sides of our dual mandate.’" The market can choose to ignore this, but it may do so at its peril.

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When They Go Low, You Go Small

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Soundbite: When the Federal Reserve starts to lower interest rates, capital historically moves to small cap stocks when company earnings are forecast to improve. That is a hallmark of a transition from an economic contraction to recovery, and it is called an early cycle. A consistent and prominent characteristic of any early cycle rally is that small market capitalization stocks perform better because they typically get sold off the hardest during a slowdown, and thanks to their higher leverage, they rebound faster as interest rates go lower. There is a gradual, almost imperceptible outperformance. For that trend to accelerate, we are looking at the National Association of Independent Business (NFIB) Economic Trends Survey. For now, there is no material improvement in sales, capital spending, or hiring, only optimism about the new depreciation rules and permanent 20% small business deduction. There needs to be positive marginal change before we buy into the view that we are about to enjoy a sustained business recovery.

We always focus on specific questions in the Survey; one of them is the percentage of firms that report it is a Good Time To Expand their business. In August, 14% of small businesses responded favorably, to which the NFIB Chief Economist responded, “Compared to readings during economic expansions, this is not a strong reading.”

The employment outlook is usually our focus in the Survey because small businesses are the marginal driver of employment. The NFIB’s economist concluded “Hiring is anemic…unfilled job openings are disappearing, but not because they are filled…it’s looking more like a ‘jobless recovery from an ‘almost recession’.” The most optimistic way to frame the data surrounding Hiring Plans for the next three months is that the trend has stabilized, and the same conclusion applies for Compensation Plans.

Another critical support for the early cycle equity outlook is improving profitability, and at least there we find a glimmer of hope. Real sales volumes are forecast to expand, and the profit picture is starting to recover. However, there is an important caveat: while the change in quarterly earnings has been the most positive since March 2023, there are still 20% more firms reporting lower earnings than higher earnings over the last quarter.

Another key area that is not rebounding is actual and planned capital spending. However, the NFIB commented that “Owners are optimistic about…the new depreciation rules and permanent 20% small business deduction will stimulate some investment spending.”

There needs to be concrete improvements to support this optimism about higher capex spending and feeling more positive about business prospects to increase borrowing. The current data is not encouraging; the percentage of owners borrowing regularly is closing in on a four-year low, and despite tariffs, the net percentage of owners raising average selling prices fell to the lowest reading of the year.

The Small Business Survey data shows that there indeed has been improvement from the lows registered in March or April, but not back to the level when President Trump took office in January and February.

Investors are sitting in the same position as small business owners, hoping that better tax and deregulation will help, despite any evidence that justifies a sustainable recovery. Bull markets may not die of old age, but they get vulnerable without a broadening participation from the underperformers.

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What to Look for This Week

(All times E.S.T.)

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1. Friday, September 26, at 8:30 a.m. August Personal Consumption Expenditure Price Index. The Cleveland Fed Inflation Nowcasting forecast is for August Core PCE to print 2.99% and to maintain that inflation rate into September. We are focused on two of Fed Governor Christopher Waller’s favorite indicators, three-month annualized Core PCE, and Market-based Core PCE. Three-month annualized PCE has risen from 1.9% in May to 3% in July, and Market-based Core PCE rose to 2.6% in July, its highest level since April 2024.

2. Wednesday, September 24 at 7:00 a.m. Mortgage Bankers Association MBA refinance index for September 19. A very curious spike came out of nowhere last week, registering the highest number in three years, and the highest weekly increase since January 2021. A sustained move in refi activity would be a warning sign, because refinancing mortgages at much higher rates would be a red flag for future consumer demand. Arguing against this possibility is the low rate of credit card delinquency rates reported at commercial banks for Q2 2025.

3. Thursday, September 25, at 8:30 a.m. Durable Goods Orders Nondefense Capital Goods Excluding Aircraft is the best measure of business spending plans, and has been rising for two years, although it only sustainably went positive in 2025. There was a rush of orders in May to avoid additional tariffs, so we will look for continuation of July strength, which was at the highest annual rise since Q4 2022.

FOMC Voters Speaking:  The most important speech could be Governor Michele Bowman on Tuesday September 23 at 9:00 a.m. to see if she is aligning more with the Fed than with Miran. Chair Powell is also speaking Tuesday at 12:35 p.m. These appear to be recent additions. First voters to speak after Powell’s press conference: Monday September 22 at 9:45 a.m. New York Fed President John Williams speaks on Monetary Policy Panel; St. Louis Fed President Alberto Musalem speaks at 10:00 a.m. on the Economic Outlook and Monetary Policy. Miran also speaks Monday at 12:00. Thursday September 25 at 8:20 Chicago President Austin Goolsbee speaks, and Williams speaks again at 9:00 a.m. later that day. We are focused on Friday’s moderated discussion with Michele Bowman, who refused with Christopher Waller to dissent for a 50-basis point rate cut at the Fed meeting, stranding Stephen Miran.

Earnings: Still going: Tuesday, September 23 Micron MU reports after the market close, and we will see if the positive sentiment can continue over its high-bandwidth memory chips going into NVIDIA’s Blackwell GPUs. Wednesday, September 24 KB Home KBH after market as building permits continue to crater in the macro data. Thursday September 25 Jabil JBL before market open. Another AI theme, this time silicon photonics that transmit data via light, not electricity that reduces both speed and power needs for data centers. Costco COST after market for more discussion about the consumer.

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By Peter Corey

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