The Fed's Shifting Priorities: Why Labor Market Weakness is Now the Dominant Driver of Rate Cuts

The Federal Reserve’s policy calculus has undergone a seismic shift in 2025, with labor market dynamics now eclipsing inflation as the primary driver of rate-cut decisions. This pivot, underscored by Bank of America’s (BofA) revised forecasts and Federal Reserve Chair Jerome Powell’s dovish signals at the Jackson Hole symposium, marks a critical inflection point for investors. As the central bank recalibrates its focus toward stabilizing employment, tactical asset allocation strategies must adapt to capitalize on the opportunities—and risks—of a dovish monetary environment.

A New Policy Paradigm: Labor Market Weakness Takes Center Stage

BofA’s August 2025 revision of its rate-cut projections reflects a stark acknowledgment of deteriorating labor market conditions. Previously forecasting zero rate cuts in 2025, the bank now anticipates two 25-basis-point reductions in September and December 2025, with three additional cuts slated for 2026 [1]. This shift follows a weak August jobs report, which revealed a slowdown in hiring and a rise in unemployment to 4.3%—a level that has prompted the Fed to prioritize job market stability over its earlier inflation-centric approach [2].

The Fed’s recalibration is not merely reactive but strategic. As BofA analysts note, “clearer evidence of deterioration in labor demand” has forced the central bank to pivot from its inflation-fighting mandate to one that balances growth and employment [3]. This is evident in Powell’s Jackson Hole remarks, where he emphasized a “shifting balance of risks” and signaled a willingness to cut rates to avert a potential labor market slowdown [4]. The market’s rapid response—surging to a 90% probability of a September rate cut—underscores the Fed’s newfound focus on employment [5].

Tactical Positioning in a Dovish Environment

The implications for asset allocation are profound. In a dovish Fed environment, sectors sensitive to lower borrowing costs and improved access to capital typically outperform. BofA’s research highlights three key areas for tactical positioning:

1. Small-Cap Equities: Historically, small-cap stocks thrive during rate-cut cycles due to their higher leverage to economic growth and cheaper financing costs. BofA and UBS have both flagged small-cap outperformance as a likely outcome of Powell’s dovish pivot, with the Russell 2000 already surging in anticipation of easing policy [6]. Investors should consider overweighting small-cap value stocks, which tend to benefit from accommodative monetary conditions.

2. International Equities: While U.S. stocks have rallied on rate-cut expectations, BofA warns of potential profit-taking in the near term, urging a shift toward international markets [7]. European and emerging market equities, in particular, could benefit from a weaker dollar and divergent monetary policies abroad.

3. High-Yield and Municipal Bonds: Fixed-income markets have already priced in much of the Fed’s dovish turn, but there remains value in sectors like high-yield corporates and municipal bonds. BofA notes that investment-grade corporates returned 0.36% and high-yield corporates 0.27% in the week following Powell’s Jackson Hole speech, reflecting renewed demand for risk assets [8]. Municipal bonds, with their tax-exempt yields and steepening yield curve, offer a compelling real return in a low-inflation environment [9].

Navigating the Risks of Over-Dovishness

Despite the case for tactical optimism, BofA cautions against overestimating the Fed’s accommodative stance. The bank warns that aggressive rate cuts could risk a policy error if the economy re-accelerates or inflation surprises to the upside [10]. Investors must remain vigilant for signs of a “too dovish” Fed, such as a rapid rebound in wage growth or a surge in inflation expectations. A balanced approach—hedging equity exposure with duration in fixed income and maintaining liquidity—can mitigate these risks while capturing the upside of a potential bull market.

Conclusion: A New Era of Policy Flexibility

The Fed’s shift toward labor market concerns signals a broader policy framework that prioritizes growth stability over rigid inflation targets. For investors, this creates a window of opportunity to position for sectors that benefit from lower rates and improved economic conditions. However, as BofA’s revised forecasts and Powell’s nuanced messaging demonstrate, the path forward remains contingent on real-time data. Strategic asset allocation in this environment requires agility, discipline, and a keen eye on the evolving interplay between labor markets and monetary policy.

Source:
[1] Bank of America now expects the Fed to cut rates after [https://www.cnbc.com/2025/09/05/bank-of-america-now-expects-the-fed-to-cut-rates-after-previously-seeing-no-moves-this-year.html]
[2] Bank of America sees two Fed rate cuts this year vs. none [https://www.investmentnews.com/wirehouses/bank-of-america-sees-two-fed-rate-cuts-this-year-vs-none-before/261982]
[3] BofA shifts stance on Fed outlook [https://www.linkedin.com/news/story/bofa-shifts-stance-on-fed-outlook-6557348/]
[4] Powell's potential rate cuts sends markets soaring [https://yieldfund.com/powells-potential-rate-cuts-sends-markets-soaring/]
[5] Markets tread water ahead of Powell's Jackson Hole speech [https://fortune.com/2025/08/19/markets-jackson-hole-stocks-fed/]
[6] BofA, UBS Latest to Join Push for Small-Cap Outperformance [https://www.bloomberg.com/news/articles/2025-08-25/bofa-ubs-see-small-cap-outperformance-as-powell-turns-dovish]
[7] BofA's Hartnett Says US Stocks to Falter After Jackson Hole [https://finance.yahoo.com/news/bofa-hartnett-sees-profit-taking-091229534.html]
[8] Weekly fixed income commentary | 08/25/2025 [https://www.nuveen.com/en-us/insights/investment-outlook/fixed-income-weekly-commentary]
[9] 6 Reasons That Would Lead to Fed Rate Cuts [https://get.ycharts.com/resources/blog/6-reasons-leading-to-fed-rate-cuts/]
[10] Weekly Market Recap Report from Bank of America Global [https://business.bofa.com/en-us/content/market-strategies-insights/weekly-market-recap-report.html]