The Fed’s Dangerous Gamble: Why Cutting Rates Into Rising Inflation Could Backfire

Cutting rates into this environment is like pouring gasoline on a smoldering fire

The Fed is facing a difficult position with both a weakening labor market and evidence of higher inflation – countervailing forces that typically call for opposite policy responses. Consumer prices rose 0.4% in August from the previous month, the sharpest increase in seven months, with the annual rate at 2.9%. The energy index increased 0.2% over the past 12 months, with electricity up 6.2%.

This creates a dangerous setup where rate cuts could further fuel inflation.

Stock Market Implications

Short-term boost likely: Markets are pricing in an 86.9% chance of a 0.25% cut in September. Historically, stocks initially respond positively to rate cuts – the S&P 500 has averaged over 13% gains in past rate-cutting cycles.

Long-term concerns: However, cutting into inflation could create a more volatile environment. If inflation reaccelerates, the Fed might need to reverse course quickly, creating whipsaw conditions. The fact that U.S. equities are historically overvalued by multiple metrics, with profit margins and valuation ratios at unsustainable highs amid weak economic growth, suggests vulnerability to any policy mistake.

Market Volatility Outlook

The VIX is currently around 15, relatively low by historical standards.

Volatility could increase significantly because:

1. Policy uncertainty: The Fed cutting while inflation remains elevated creates unprecedented uncertainty about future policy direction

2. Conflicting signals: The Fed is trying to balance employment and inflation risks when one side of the dual mandate says it should be cutting and the other side says it should be hiking.

3. Asset bubble risks: With current asset prices, including U.S. stocks and real estate, at extreme valuations due to years of easy monetary policy, any policy misstep could trigger sharp corrections

The Electricity Price Wild Card

Electricity prices have jumped more than twice as fast as the overall cost of living in the last year due to the exploding demand from data centers. This is particularly concerning because:

• It’s a non-discretionary expense affecting all businesses and consumers

• The average household power bill is expected to jump to nearly $800 from June to September, marking a 12-year record

• Rising electricity costs feed directly into core inflation metrics

Assessment

Cutting rates into this environment is like pouring gasoline on a smoldering fire. The Fed appears trapped between:

• Political pressure for aggressive cuts

• A softening labor market that traditionally warrants easing

• Persistent inflation that should call for tighter policy

• Asset prices already in bubble territory

Expectations:

1. Initial market euphoria followed by growing concerns about inflation

2. Increased volatility as markets struggle to price in conflicting signals

3. Sector rotation toward inflation beneficiaries (commodities, energy, real assets)

4. Potential policy reversal if inflation reaccelerates, causing market turmoil

The combination of rising electricity prices, elevated asset valuations, and inflation above target while cutting rates creates a highly unstable equilibrium. This could be the policy mistake that triggers the next significant market correction, though timing remains uncertain.