CONTRIBUTORS
Sonal Desai, Ph.D.
Chief Investment Officer,
Portfolio Manager
In its October meeting, the Federal Reserve (Fed) may have delivered the last rate cut of this year—possibly the last of this easing cycle. At the same time, though, the Fed seems set to give an extra helping hand to the government with its still-substantial borrowing needs.
The Fed cut interest rates by another 25-basis-points (bps), after a similar reduction in September. The October rate cut was telegraphed, and markets were fully expecting it. But right off the bat, Fed Chair Jerome Powell shifted the focus to the next policy meeting, noting that another rate cut in December “is not a foregone conclusion, far from it.” He repeated the point later in the press conference, underscoring the “far from it” bit, suggesting that the current baseline should be for rates to stay on hold, barring an unexpected weakening in growth and jobs data.
The emphasis on December was for two connected reasons, in my view. First, to divert attention from the fact that the current economic conditions and outlook don’t really justify the October rate cut either. Second, to cool the enthusiasm of financial markets, which expected fed funds to fall to 3% by the middle of next year—an additional easing that the current data and outlook would not justify.
Inflation has been stuck at around 3% for about two years now, since June 2023. To claim some success in disinflation, Powell had to reference a decline from 2022 levels. Risks, as he acknowledged, remain tilted to the upside.
Headline Inflation Oscillating Around 3% as Supercore Services Remain Sticky, Core Goods Rising
2020–2025
Sources: BLS, Macrobond. Analysis by Franklin Templeton Fixed Income Research. As of October 30, 2025.
Economic growth is proving resilient: Gross domestic product (GDP) grew at about 1.6% in the first half of the year, and the Atlanta Fed sees it expanding at close to 4% in the third quarter. This is driven not just by the much-discussed artificial intelligence (AI) investment boom, but also by healthy household consumption, and it is helped by a narrowing trade deficit.
In the labor market, hiring and vacancies have declined, but Powell himself characterized this as mostly driven by decelerating labor supply, with constrained immigration and a decline in the participation rate. Demand has slowed as well, but not much more than supply—the unemployment rate is only marginally higher than in mid-2024 and still consistent with the Fed’s full-employment estimates.
A narrative has taken hold in the media of ongoing and looming large-scale job cuts, with AI eating up white-collar jobs. Amazon’s announcement that it would eliminate 14,000 corporate jobs has made front-page headlines. To put things in perspective, this would amount to just 4% of Amazon’s 350,000 corporate employees—and less than 1% of its 1.5 million global workforce. As a recent Wall Street Journal article on the topic noted, US executives “hope” that AI will eventually take over many white-collar jobs—but there is little evidence in the data that this is already happening. Pressed to show efficiency gains against massive AI investments, corporate executives are likely to mention AI in the same breath as job cuts to make their organizations leaner. Beyond headline-worthy anecdotes, however, the macro data do not show evidence of large scale layoffs.
Against this resilient background, both growth and inflation are set to experience tailwinds early next year. Some of the tax cuts in the “Big Beautiful Bill” will kick in, providing an estimated boost of about US$300 billion (about 1% of GDP) in 2026. This would include tax deductibility on tips and overtime, the higher state and local taxes deduction cap, the higher child tax credits and a broadened and permanent qualified business income deduction. And while I do not expect tariffs to give a meaningful sustained impulse to inflation, as I have argued in previous notes, they might create an additional temporary tailwind just as fiscal stimulus gains traction. That’s all the more reason for the Fed to refrain from a December cut: It would be quite awkward if inflation were to accelerate again right after a series of rate cuts.
The most interesting part of the meeting, in my view, was the shift in balance sheet strategy. Starting December 1, the Fed will halt quantitative tightening and reinvest all principal payments from maturing holdings of agency securities into Treasury bills. This neatly mirrors the Treasury’s decision to rely on increased issuance of short-term T-bills to finance its sizable deficit. The Fed is not returning to quantitative easing, since the balance sheet size will be held constant. But it will lend a very helping hand to a still profligate government.
Balance Sheet Size Remains Frozen at Current Levels; Composition Will Change to Reflect Higher T-Bill Holdings
2008–2025
Sources: Fed, Macrobond. Analysis by Franklin Templeton Fixed Income Research. As of October 30, 2025. MBS represents Mortgage-Backed Securities, T-Bills are Treasury Bills.
I would boil all this down to two takeaways:
First, the economic outlook at this stage does not warrant any additional monetary easing—as I have been arguing. This is especially true as we are likely to see at least an uptick in inflation as we cross into 2026.
Second, fiscal dominance has emerged as the strongest factor for monetary policy. In the post-COVID-19 recovery, Fed monetization of burgeoning government deficits triggered a sharp inflation spike. This time around, the fiscal deficit is projected to remain broadly unchanged, and the Fed has pledged to freeze the size of its balance sheet; together, these two factors should avoid a repeat of 2022. But the Fed’s decision to accommodate persistently large fiscal deficits will do nothing to encourage fiscal prudence and might add to inflation risks down the line.
As Powell spoke, yields across the US Treasury yield curve moved up by about nine bps, not a major move. As I already mentioned in my last “On My Mind”, we remain neutral on duration (a measure of interest-rate risk), because we see scope for rates to move further up. Given the resilience of the economy, a gradual grind higher in bond yields should in our view be consistent with continued good performance on risky assets. Loans, in particular, would benefit from a scaling back of Fed rate-cut expectations. We also see the outcome of this Fed meeting as consistent with the dollar remaining range-bound in the near term.
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