Fed, under pressure to cut rates, tries to balance labor market and inflation – while avoiding dreaded stagflation

Interest rates are a tricky balancing act, as Fed Chair Jerome Powell knows well. AP Photo/Alex Brandon

The Federal Reserve is in a nearly impossible spot right now.

Markets are expecting a quarter-point interest rate cut to a range of 4% to 4.25% when the Fed policy-setting committee concludes its latest meeting on Sept. 17, 2025. After all, the slowdown in the jobs market, as well as a massive revision to past figures showing close to a million fewer jobs were created than previously reported, makes a strong case for lower interest rates to shore up the economy.

But at the same time, inflation – the other component of the Fed's dual mandate – has begun to accelerate again. As rising tariffs squeeze consumer spending in sectors exposed to the harshest tariffs – such as clothing and electronics – other inflationary pressures loom over the horizon.

A slowing economy or rising inflation is a circumstance that policymakers want to avoid. But as an economist and finance professor, I'm increasingly concerned about the risk that they happen at the same time – a horrible economic condition known as stagflation – and that the Fed may be too slow in responding.

Between a rock and a hard data point

The Fed has been under pressure to cut rates for some time – including from President Donald Trump.

The reason markets and the White House are so interested is because what the Fed does matters. The central bank's decision at its near-monthly meetings helps banks and other lenders to determine rates on auto loans, mortgages, credit cards and more. Lower rates usually lead more businesses and consumers to borrow and spend more, boosting economic activity. This also can drive up inflation.

For the better part of three years, the central bank has been focused on its generational fight against inflation. But now, with inflation down significantly from its 40-year high of 9% reached in 2022 and the jobs market sputtering, conditions finally seemed right to resume cutting rates.

The labor market has seen continued deterioration, most notably with the Bureau of Labor Statistics' revisions to nonfarm payrolls – in effect reducing the number of jobs economists thought the U.S. gained by almost 1 million for the year ending in March 2025.

But a recent uptick in inflation has made the Fed's call more complicated.

Over the past four months, the consumer price index has consistently ticked up, with the most recent CPI figure indicating year-over-year inflation of 2.9% – well above the Fed's target of 2%.

Switching focus to jobs

At the Fed's last meeting in August, Chair Jerome Powell said that the risks to the labor market now exceed the risks of inflation.

For example, for the first time since 2021, the number of unemployed people have outpaced job vacancies as companies have moved to eliminate open positions before laying off workers.

Most compelling is the so-called U6 unemployment rate – which includes those in the regular unemployment figures and people who have stopped looking for jobs, as well as those who are working part time but are looking for full-time opportunities. That has increased over the past three months to 8.1%.

The evidence suggests that businesses are reluctant to add workers as tariff policy and broad economic uncertainty appear to drive hiring decisions.

The last time there was stagflation was the 1970s, which led to long lines for cars ≠ and mowers – at the gas stations. AP Photo

The worst of both worlds

The short-term risk here is that a quarter-point cut won't be enough to shore up the jobs market, and it may be too late to prevent the economy from tipping into recession.

The longer-term risk is more concerning: Not only could the economy contract, but it could do so while inflation accelerates.

The last time the U.S. experienced stagflation was in the 1970s, when an oil embargo caused the price of crude to double. This drove up inflation while causing unemployment to soar and the economy to stall. Policies aimed at reducing inflation typically exacerbate slowing growth, and vice versa. In other words, there were fewer dollars to go around – and those dollars were worth a little less every day.

The pain experienced during this previous bout of stagflation convinced a generation of economists and policymakers that the condition was to be avoided at all costs.

The Fed, which has consistently shown its hand and has guided the markets toward this week's rate cut, now has to make what seems like an impossible decision: cut rates even if doing so will add inflationary pressures.

And there are other potential headwinds for the U.S. economy. For example, it has yet to fully absorb the impact of Trump's immigration crackdown on productivity and output due to the loss of workers. Waning consumer confidence suggests consumer spending could soon drop. And a potential federal government shutdown looms in September.

In my view, it's clear that a cut is warranted. But will it drive up inflation? Economists like me will be watching this closely.

Jason Reed does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.