The Fed's August Inflation Data and the Diminishing Chances of a 50-basis-point Rate Cut

The Federal Reserve's August 2025 inflation data has sparked a recalibration of market expectations, with the likelihood of a 50-basis-point rate cut now appearing increasingly remote. While the 95% probability of a 25-basis-point reduction in September remains intact, the data underscores a nuanced shift in the Fed's calculus. This recalibration is reshaping risk assets, from equities to bonds and the U.S. dollar, as investors grapple with the implications of a more cautious central bank.

The Inflation Narrative: Goods vs. Services

The latest Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) data reveal a mixed picture. For July 2025, the CPI rose 0.2% monthly (2.8% YoY), with core CPI at 0.3% monthly (3.0% YoY). The PCE Price Index, the Fed's preferred gauge, showed a 2.6% annual increase in June, with core PCE at 2.8%. These figures suggest inflation is still anchored by goods—tariff-driven price hikes in used cars, household furnishings, and airline fares—rather than services, which have shown a modest slowdown.

However, the Fed's internal debate is intensifying. While goods inflation may be transitory, services inflation remains a wildcard. A resurgence in services—such as shelter or healthcare—could force the Fed to delay aggressive easing. As JPMorgan's Priya Misra notes, “If services inflation reaccelerates, the Fed's hands will be tied.” This uncertainty has already tempered market expectations for a 50-basis-point cut, with futures markets now pricing in a 62% chance of a second 25-basis-point cut in October, rather than a larger move.

Equities: Sector Rotation and Valuation Pressures

The equity market's response to the Fed's cautious stance has been a rotation toward sectors less sensitive to interest rates. Defensive sectors like utilities and healthcare have outperformed, while growth stocks—particularly those in artificial intelligence and semiconductors—have faced headwinds. This shift reflects investor concerns that prolonged higher rates will compress valuations for high-growth companies.

For example, the S&P 500's AI subsector has underperformed by 8% since mid-July, as investors reassess the cost of capital. Conversely, dividend-paying sectors like consumer staples and industrials have gained traction. A would reveal this divergence.

Investors should also monitor the impact of inflation on corporate earnings. While goods-driven inflation may benefit manufacturers, it could erode margins for retailers and service providers. A would highlight this dynamic.

Bonds: Yields Stabilize Amid Policy Uncertainty

The bond market has priced in a more gradual easing path, with 10-year Treasury yields stabilizing near 3.8% in early August. This reflects a balance between inflation risks and the Fed's commitment to avoiding a rate hike. However, the diminishing chance of a 50-basis-point cut has reduced the urgency for a yield spike.

The key risk for bondholders lies in the Fed's potential pivot to a “higher for longer” stance if services inflation surprises to the upside. This scenario would favor short-duration bonds and Treasury Inflation-Protected Securities (TIPS). A would illustrate the market's expectation of a flattening curve, signaling a preference for shorter-term instruments.

The Dollar: A Tale of Two Forces

The U.S. dollar has benefited from the Fed's hawkish tilt, with the DXY index rising 1.2% in July. However, this strength is being offset by global economic fragility, particularly in emerging markets. The dollar's trajectory will hinge on the Fed's ability to differentiate its policy from other central banks.

For instance, the European Central Bank (ECB) has signaled a 25-basis-point cut in September, while the Bank of Japan remains accommodative. This divergence supports the dollar in the near term but could erode its appeal if the Fed delays further cuts. A would underscore this interplay.

Investment Implications

1. Equities: Prioritize sectors with pricing power and resilient cash flows, such as healthcare and industrials. Avoid overexposed growth stocks in AI and semiconductors.
2. Bonds: Allocate to short-duration Treasuries and TIPS to hedge against inflation volatility. Avoid long-duration corporate bonds.
3. Currency: Maintain a defensive stance in the dollar, but monitor ECB and BoJ policy moves for potential reversals.

The Fed's August data has not derailed the rate-cut narrative but has tempered its pace. As the September meeting approaches, investors must remain vigilant to the Fed's balancing act between inflation control and labor market support. The 50-basis-point cut may be a relic of the past, but the 25-basis-point path offers a more sustainable path forward—one that demands agility in portfolio construction.