The Fed's Cooling Inflation Narrative: Is the Bull Case for Equities Now On Solid Ground?

The September 2025 Personal Consumption Expenditure (PCE) report, delayed by a government shutdown, has reignited debates about the Federal Reserve's inflation-fighting trajectory and its implications for equities. With headline PCE inflation rising 0.3% month-over-month and annual inflation settling at 2.8%-a slight deceleration from the previous month's 2.9%-the data suggests a tentative easing of price pressures. Core PCE, which excludes food and energy, mirrored this trend, climbing 0.2% monthly to an annual rate of 2.8%. While still above the Fed's 2% target, these figures have bolstered investor optimism that the central bank is nearing a pivotal inflection point in its policy cycle.

The Fed's Balancing Act: Inflation, Employment, and Rate Cuts

The Federal Open Market Committee (FOMC) has long grappled with the tension between inflation and employment risks. At its September 16–17 meeting, the Fed responded to a softening labor market-marked by a 4.3% unemployment rate in August and slowing job gains-by cutting the federal funds rate by 25 basis points to a range of 4.00%–4.25%. This decision, the first rate cut in over a year, reflected a shift in the Fed's risk calculus. As stated in the FOMC minutes, officials acknowledged that "inflation remained elevated but risks had shifted more toward employment." The September PCE report, with its modest cooling, reinforced this narrative, with traders now pricing in an 87% probability of a 25-basis-point cut at the December 10 meeting.

The Fed's cautious optimism is further underscored by its updated economic projections. Median FOMC participants now anticipate a cumulative 100 basis points of rate cuts by the end of 2026, with core PCE inflation expected to fall to 2.6% in 2026 and 2.1% in 2027. These forecasts, however, hinge on the assumption that inflation will continue to trend downward without triggering a resurgence in wage growth or supply-side disruptions.

Equity Markets: Riding the Rate-Cut Wave

The equity market's reaction to the PCE report and the Fed's dovish pivot has been robust. The S&P 500 surged 0.5% in the wake of the data release, with large-cap and AI-driven stocks leading the charge. By early December, the index was trading near record highs, while the Dow Jones Industrial Average flirted with all-time levels. This rally reflects a broader re-rating of risk assets, driven by the expectation that lower borrowing costs will stimulate economic growth and corporate earnings.

Institutional forecasts further validate this bull case. JPMorgan analysts note that markets are now pricing in a cumulative 87 basis-point easing cycle by the end of 2026, with the federal funds rate projected to reach 3.125% by 2027. Such a trajectory would provide a tailwind for equities, particularly in sectors sensitive to interest rates, such as real estate, utilities, and consumer discretionary.

However, the bull case is not without caveats. Persistent inflation-core PCE remains 0.8 percentage points above the Fed's target-and lingering labor market fragility introduce volatility. As highlighted by KPMG, consumer spending on goods slowed in September due to higher prices on vehicles and apparel, while services spending, though resilient, faces headwinds from rising childcare and healthcare costs. These dynamics suggest that while the Fed's easing cycle may support equities, a return to pre-pandemic growth norms is unlikely without a more decisive drop in inflation.

The Path Forward: Solid Ground or Shifting Sands?

The September PCE report has undoubtedly strengthened the case for equities, particularly in the context of anticipated rate cuts. Yet, the bull case rests on two critical assumptions: that inflation will continue to trend downward and that the Fed will maintain a dovish stance despite potential shocks to the global economy. The latter risk is heightened by the possibility of trade policy shifts under the Trump administration, which could reignite inflationary pressures.

For now, investors appear to be betting on a smooth transition to a lower-rate environment. The S&P 500's performance in early December suggests that markets are discounting a "soft landing" scenario, where inflation cools without triggering a recession. However, as the Fed's own projections caution, the path to 2% inflation remains uncertain. Until price pressures fully align with the central bank's target, the bull case for equities will remain contingent on the Fed's ability to navigate this delicate balancing act.