Doha, Qatar: Policy rates expectations have swung significantly in recent months, revealing a rather fragile market consensus over the timing and size of easing by the US Federal Reserve (the “Fed”) over the next year. After keeping the rate on hold since the end of 2024, an incipient softening of labour markets began to shift the balance of risks.
Unprecedented trade and fiscal policy volatility drove uncertainty measures to record highs, putting policy makers on “wait-and-see” mode as they assessed the major risks to the economy. Finally, the Fed cut the benchmark rate by 25 basis points (b.p.) to 4.25% in September, QNB said in its economic commentary.
The Fed recognizes that near-term risks to inflation are tilted to the upside, with the headline figure fluctuating around 2.9%, markedly above the 2% target of monetary policy, while risks to employment point to the downside. This puts the Fed in a difficult position, as the two targets of the Fed’s mandate, i.e., low inflation and maximum employment, come into direct conflict.
Currently, markets discount close to 125 b.p. in additional rate cuts until end-2026. In our view, although the Fed would eventually bring interest rates to the neutral level close to 3%, there is not an alarming deterioration in the economic growth outlook that would call for a rate cutting cycle of this speed. In this article, we discuss three main factors that support our outlook.
First, labour markets are weakening gradually, in line with a soft-landing of the economy. Labour markets are at the core of monetary policy, explicitely being part of the mandate of the Federal Reserve, and therefore provide guidance regarding the direction of policy rates. Importantly, labour markets are an informative gauge of the state of the overall economy, and a sharp deterioration in employment has historically anticipated a recession. The widely recognized “Sahm Rule” states that a recession is imninent when the unemployment rate increases by 0.5 percentage points (p.p.) relative to the minimum in the last year. This rule has signalled the start of every US recession since the 1970s, but the current progression of the unemployment rate is overly moderate to raise the alarms of a downturn.
The August unemployment print of 4.3% still stood in the range that is considered consistent with balanced employment. More importantly, even taking into account the emerging impact of AI on the job market, market consensus points to an unemployment rate of 4.4% by end-2026. Overall, the mild softening of labour markets calls for a more gradual easing of monetary policy than expected by markets.
Second, the leading indicators for the services sector still point to positive, even if modest, expansion. The latest prints of the Purchasing Managers Index (PMI) signal that the outlook remains stable for services.
The PMI is a reliable survey-based indicator that provides a measurement of improvement or deterioration in economic activity. An index level of 50 serves as a threshold that separates contractionary (below 50) from expansionary (above 50) business conditions.
Third, the contraction in the manufacturing activity is still contained, showing that the sector remains resilient. Although the manufacturing sector is significantly smaller than services, representing just around 11% of GDP, it is more sensitive to economic shocks and tends to be accurate in anticipating the overall performance of the economy. For example, the manufacturing PMI has reliably anticipated US recessions when it falls below 45, since the 1950s.
In addition to skilled-labour shortages, manufacturers are facing significant disruptions in their supply chains caused by the sweeping tariffs initially announced by President Trump on “Liberation Day” in early April. Increased uncertainty has placed producers on waiting mode, until there is further clarity on tariffs across sectors and foreign countries and, therefore, on costs of imported inputs.
All in all, leading indicators from key sectors show that the US economy is heading to a soft- deceleration, with real GDP growth for 2026 expected at 1.7%. A resilient labour market, a still-expanding services sector, and a moderate contraction in manufacturing support this outlook. In our view, given a likely soft-landing scenario rather than a sharp contraction, we expect a less aggressive monetary easing cycle than the market consensus, with the FOMC cutting its policy rate by 25 b.p. twice more this year, and one more time in 2026 to a policy rate of 3.5%
