Why I’ll be cautious about further rate cuts

It is a pleasure to welcome you all to the Dallas Fed and to thank you for sharing your perspectives with us. The insights you share help me form my assessment of our region’s economy and shape my overall outlook.

The U.S. economy is at a key moment for monetary policy. More than four years after the postpandemic inflation surge began, inflation remains above the 2 percent target set by the Federal Open Market Committee (FOMC). At the same time, payroll job growth slowed markedly this year. Against this backdrop, the FOMC recently voted to cut interest rates for the first time in nine months, and FOMC participants’ economic projections reflected a divergence of views on where policy should go from here.

Congress gave the FOMC a dual mandate: to set monetary policy to deliver both price stability and maximum employment. I supported the FOMC’s rate cut earlier this month because it helped better balance the risk of slowing the labor market too much against the ongoing imperative to bring inflation back to the 2 percent target. However, I am also committed to finishing the job of sustainably restoring price stability.

As I consider the path ahead, three features of the economy stand out to me at this time.

• First, even setting aside temporary effects of this year’s increases in tariff rates, inflation is not convincingly on track to return all the way to 2 percent.
• Second, aggregate demand remains resilient, supported by consumption, business investment and buoyant financial conditions.
• Third, while the labor market has undeniably slowed, with meaningful costs to workers, not all of the weakness represents economic slack that less-restrictive monetary policy can ameliorate.

The combination of persistent inflation, resilient demand and modest labor market slack indicates to me that policy is likely only modestly restrictive. There may be relatively little room to make additional rate cuts without inadvertently moving to an inappropriately accommodative stance.

Of course, economic outlooks are inherently uncertain, and the outlook now is more uncertain than usual. In these remarks, I will lay out the key elements of my economic outlook and why they lead me to conclude that the FOMC should proceed cautiously on further rate cuts. As always, these are my views and not necessarily those of my FOMC colleagues.

Inflationary pressures persist

Inflation remains too high. The FOMC measures price stability by the price index for personal consumption expenditures, or PCE. Headline PCE inflation was 2.7 percent for the 12 months through August.

Inflation can be volatile. Measures that remove outliers or volatile categories historically have given better signals of where headline inflation is likely to go. But the signals from these measures are currently disappointing. The Dallas Fed trimmed mean PCE inflation rate, which removes categories of goods or services with unusually large price changes, was also 2.7 percent in the 12 months through August. Core PCE inflation, which removes the volatile food and energy categories, was higher than headline, at 2.9 percent. Both measures are little changed from their readings a year ago.

Tariff rate increases have contributed to inflation this year. But, in standard economic theories, an increase in tariffs, all else equal, produces a one-time upward shift in the price level rather than sustained inflationary pressures. Therefore, to judge whether inflation is on track to return all the way to 2 percent, it is important to assess the underlying drivers beyond tariffs.

My staff investigated what has been keeping inflation elevated. They separated core inflation into three components: goods, housing services and non-housing services. When overall inflation is running at 2 percent, each of these three components tends to run at a somewhat different rate because long-run trends change the relative prices of different goods and services. However, my staff found that inflation for all three components is elevated relative to the respective levels that would be consistent with 2 percent overall inflation.

Most worrisome for the medium-term inflation outlook, non-housing services inflation should be relatively unaffected by tariffs, yet it has hovered near 3.4 percent over the past year. Non-housing services represents more than half of Americans’ aggregate consumption. My staff estimates that the current rate of inflation in this category is high enough to keep overall inflation above 2 percent by 30 to 40 basis points. Housing services inflation should come down some as rents reset. Core goods inflation has been elevated in part due to tariffs, an effect that should also dissipate. But even then, the persistence visible in non-housing services inflation would keep overall inflation from returning all the way to the 2 percent target.

There are both downside and upside risks to that outlook. If the labor market slows more sharply than I anticipate, or if labor productivity growth strengthens, we could see more disinflation. On the other hand, shifting global supply chains and the re-shoring of manufacturing could continue to push up goods prices even after tariff effects are fully incorporated.

Tariffs also pose upside risk to inflation because of the way they tend to feed into prices over time. Although tariffs should produce a one-time shift up in prices, in practice that upward shift takes time to occur. The resulting lags have the potential to generate more persistent inflation. Many business leaders tell me they have not yet fully passed through higher tariff costs because they are uncertain where tariff rates will settle and fear losing market share. Other firms held the line on prices while they worked through inventories built up before tariffs took effect. But if tariff costs remain high, my business contacts tell me they will pass on more of these costs to their customers. Responses to special questions in the Dallas Fed’s Texas Business Outlook Survey in August indicate a significant fraction of firms affected by tariffs had not yet passed on tariff costs but plan to do so in coming months.

Surveys indicate that consumers’ and business economists’ inflation expectations remain elevated over the next year, as do market-based measures of inflation compensation. Measures of longer-run inflation expectations and inflation compensation have generally remained broadly consistent with 2 percent inflation. Well-anchored inflation expectations help return inflation to target and give the FOMC room to take a balanced approach to the two legs of the mandate. However, policymakers cannot take well-anchored expectations for granted. The longer tariffs take to show through into prices and the longer inflation remains above 2 percent, the greater the risk that above-target inflation becomes entrenched.

Demand is holding up in the face of challenges

Aggregate demand has remained resilient despite an elevated monetary policy target rate and cross-currents from shifts in national economic policies. Adjusting for inflation, GDP increased at a 1.6 percent annualized rate in the first half of the year, slower than its 2.4 percent pace in 2024 but not much below its trend growth rate. As with inflation, GDP measures that exclude volatile categories often give more reliable signals than the total GDP data on the underlying momentum in overall spending and demand. Final sales to private domestic purchasers, which excludes government spending and the more volatile net exports and inventories categories, increased at a 2.4 percent annualized pace in the first half of 2025. Corporate earnings reports for the second quarter also underscored economic resilience.

Moreover, GDP growth in the third quarter looks solid. Consumption has increased at around a 3 percent annualized pace for the quarter, and new orders suggest equipment investment remained strong in July and August.

Consumer and business sentiment appear to be rebounding after having weakened in the spring in the face of uncertainty regarding trade and fiscal policies. The Dallas Fed’s August Texas Business Outlook and Banking Conditions Surveys found that business output, wages and loan volumes picked up since the middle of the summer, which is consistent with surveys at the national level. New orders in the Institute for Supply Management’s surveys for both manufacturing and services jumped into positive territory in August. In the Dallas Fed’s September surveys, respondents also expect manufacturing and service sector activity to continue to increase six months from now, consistent with findings in other regions.

The outlook for business investment in some sectors is particularly strong. Investment in data centers for both traditional cloud services and artificial intelligence continues to boom. My business contacts also cite changes in tax policy, the prospect of less restrictive regulation in banking and other sectors and, perhaps more speculatively, permitting reform that could unlock energy development and housing construction. These developments may well eventually increase productivity and aggregate supply, but the timing of those effects is uncertain. Meanwhile, the boost to demand is already here. That raises uncertainty about the balance between demand and supply in the near term.

Increasingly accommodative financial conditions are supporting aggregate demand, primarily through equity valuations that continue to reach new highs, but also through narrowing credit spreads and a weaker dollar. Indexes that estimate the economic impact of changes in a broad range of asset prices point to financial conditions prompting a meaningful boost to growth ahead. For example, the Federal Reserve Board’s baseline methodology implies that current financial conditions will provide about a 1 percentage point boost to real GDP growth over the next year. More than half of the effect comes from higher equity valuations. This is largely because rising financial wealth tends to support aggregate consumption, and the last year alone saw an estimated increase in U.S.-held public equity wealth of more than $7 trillion. Of course, not everyone benefits equally or at all from increases in stock prices, and financial conditions are less supportive in certain sectors. High mortgage rates, for example, are weighing on house prices, which have been edging lower in recent months from high levels. But, overall, financial conditions are providing a tailwind to aggregate growth.

Distinguishing labor market slowing from labor market slack

Despite the resilience in aggregate demand, the labor market has been slowing. Payroll job growth has decreased markedly this year. The economy added an average of 111,000 jobs per month in 2024 after accounting for preliminary benchmark revisions recently published by the Bureau of Labor Statistics. By contrast, payrolls grew by an average of 29,000 jobs per month from June to August 2025, a number that could eventually be revised downward as well.

Yet employers are not laying off markedly more workers than before. The layoff rate in August was 1.1 percent, below the average of 1.2 in 2019, when the labor market was considered healthy. Initial claims for unemployment insurance remained around the 2019 level through mid September.

Instead, the labor market is characterized by both low hiring and low firing. Firms are reluctant to hire, and workers seeking jobs (including those who have been laid off, those who would like to change roles and new entrants to the labor force) are having more difficulty finding positions. Although layoffs are painful in any environment, if hiring is robust, workers can find new jobs relatively quickly. The current low hiring rate makes the economy more vulnerable than usual to any increase in layoffs or weakening in demand.

But I’m also mindful of the difference between a slowing labor market and a slack labor market. By slack, I mean underutilization of economic resources, such as a gap between the number of people wanting to work and the number of available jobs. Monetary policy can ameliorate slack by lowering the policy rate to support demand. But not all changes in economic activity represent changes in slack, and monetary policy can do little to change supply factors. Stimulating demand when it is already in balance with supply will create price pressures without sustainably adding to employment. For example, in the 1970s, the FOMC misinterpreted slowing productivity growth and GDP growth as increasing slack, and it lowered rates only to stoke inflation.

While payroll gains have slowed considerably, so has labor force growth. At the Dallas Fed, we estimate that the break-even level of monthly job gains needed to keep the unemployment rate constant fell from a peak of approximately 250,000 in 2023 to about 30,000 in mid-2025. Declines in immigration account for roughly half of the decline in the break-even estimate, and a lower labor force participation accounts for the rest. Research by my staff shows that a decline in immigration can also reduce demand, which offsets the reduced labor supply and leaves the economy smaller but overall balanced with little effect on inflation.

Unemployment has drifted up only slowly, consistent with payroll gains only modestly below breakeven. The unemployment rate registered 4.3 percent in August, after hovering in a range of 4 to 4.2 percent from mid-2024 through July of this year. Other labor market indicators, such as job openings and wage growth, also point to continued gradual cooling but not a rapidly weakening labor market. As of August, there was one job opening per unemployed worker, just a bit lower than the average ratio of 1.1 from 2017 to 2019. Over the past year, employee compensation growth has been close to 3.5 percent, which is lower than during the peak inflation surge but higher than before the pandemic.

That said, while the increase in labor market slack to date has been incremental, I am mindful that the unemployment rate has rarely moved so gradually. Modest increases have often turned into large increases. As the labor market has cooled, its vulnerability to a very damaging, nonlinear deterioration has increased.

How restrictive is the policy stance?

The degree of restriction coming from monetary policy is difficult to measure precisely, especially in real time. On the whole, however, the state of the economy and financial conditions indicate to me the stance of monetary policy is only modestly restrictive. Quantitative economic models also support that view.

Inflation, though down substantially from the postpandemic peak, has not made meaningful further progress toward our target for the past year. That persistence is driven, in part, by core non-housing services inflation, which is linked to wage growth and the labor market. The labor market, while slowing, does not appear to have a large or rapidly increasing amount of slack. Consumption and business investment also remain resilient. More qualitatively, my contacts tell me of growing optimism, and they expect business activity to increase. Recent surveys also reflect improving sentiment. None of this is what I would expect to see if the stance of policy were more than modestly restrictive.

It is true that monetary policy works with a lag, so economic conditions today do not reflect the full impact of the current policy setting. But if substantially more cooling of the economy were in train, I would not have expected progress on underlying inflation to stall.

Financial conditions tell a similar story. Overall, rising asset prices and solid credit flows are supporting economic activity and signaling investor optimism for future economic growth. There is meaningful financial restraint in some sectors, especially housing. On the whole, though, these financial conditions do not indicate that monetary policy stance is exerting a lot of restraint on economic activity.

Another way to assess the restrictiveness of policy is to compare the fed funds target range to estimates of the neutral interest rate, the theoretical interest rate that would act as neither a headwind nor a tailwind to growth. The neutral rate is notoriously uncertain and difficult to measure, but you can get a sense for it from economic fundamentals, models, surveys and market prices.

Economists employ a range of models to try to estimate the neutral rate. Among widely consulted models, point estimates of the neutral real interest rate currently range from 0.84 percent to 2.15 percent. Adding in the 2 percent inflation target, those figures correspond to a neutral fed funds rate of 2.84 to 4.15 percent. Following the rate cut at the September FOMC meeting, the fed funds rate stands today at 4.13 percent, right at the top of that range.

Model-based estimates can be slow to respond to structural changes in the economy. Market prices provide a helpful complement to the models because market prices should incorporate all available information and reflect whatever can be known about those structural changes as of today. The real interest rate on Treasury Inflation-Protected Securities five to 10 years from now is currently around 2.3 percent, equivalent to a 4.3 percent nominal interest rate after adding in the 2 percent inflation target. Five to 10 years from now is far enough in the future to limit price impacts from the current monetary policy cycle and give an indication of where market participants expect the neutral rate to settle in the future. (Importantly, though, the neutral rate could be different today than in the future, and risk premiums and technical factors can also influence market measures.) Real five-year, five-year forward yields derived from interest rate and inflation swaps currently trade at around 1.4 percent, equivalent to a 3.4 percent nominal rate after adding 2 percent inflation. The market proxies from TIPS and swaps thus both suggest expectations for long-run neutral real interest rates that are comparable to model-based estimates and not far from the current policy rate.

Importantly, the range of estimates of the neutral rate is quite large, as are the uncertainty bands around some of the individual estimates. In considering the appropriate stance of monetary policy, I believe it is important not to lean too heavily on any one estimate, and to formulate a plan that is robust to the uncertainty.

The FOMC’s recent action and the policy path ahead

I supported the FOMC’s decision to lower the federal funds rate by 25 basis points at our September meeting. Moving the rate one notch closer to neutral provides some insurance against the downside risks to the labor market. At the same time, the stance of policy remains modestly restrictive and capable of continuing to reduce inflation to the 2 percent target.

However, I will be cautious about further rate cuts. It is critical for the FOMC to keep its commitment to deliver 2 percent inflation. Achieving this will require carefully calibrating the stance of policy.

The gradual increase in labor market slack to date is what I expected and what is necessary to bring inflation down. Non-housing services inflation, in particular, is tightly correlated with wage growth and, ultimately, labor market tightness. With non-housing-services inflation running above the rate consistent with overall 2-percent inflation, a modest further increase in labor market slack is likely necessary to finish restoring price stability.

In turn, that requires maintaining at least a modestly restrictive policy stance. Yet the neutral rate is uncertain. Lowering the policy target too much would risk moving to a neutral or even accommodative stance that would prevent further progress on price stability. It will take time to observe how the economy is evolving and learn how much room there is for further cuts. We will also learn more over time about the persistence of underlying inflation and the degree of downside risk to the labor market. A cautious approach to policy will enable that learning and help balance both of the FOMC’s dual mandate goals and the risks to each of them.

I approach the economic outlook and policy strategy with humility. Any number of economic or financial developments could require a more expeditious change in the course of policy or a fundamental rethink of the outlook. Handling those possibilities, too, calls for a learning mindset. I will continue to closely watch the economic data, financial conditions, economic models and what our surveys and contacts tell me as I assess appropriate monetary policy.