Alberto Musalem, President of the St. Louis Federal Reserve Bank, addressed the need for caution in Federal Reserve policy at the Institute of International Finance meeting. He suggested another rate cut might be possible if job risks increase and inflation remains subdued. Musalem stressed the importance of the Fed not adhering to a preset course and adopting a balanced approach in monetary policy decisions.

Impact of Tariffs on Economy

Musalem expressed concerns about the impacts of tariffs on the economy, which may continue into next year. Retailers are facing pressure to pass on tariff costs, affecting consumer purchasing power, yet tariffs are not influencing service inflation. Musalem supports targeting a 2% inflation rate, predicting a return to this level by the second half of 2026.

He noted that the job market, close to full employment, is cooling due to immigration changes, setting the breakeven rate for jobs at 30,000 to 80,000. Despite these challenges, he doesn’t foresee imminent problems in the job market. Musalem emphasised that monetary policy is currently between restrictive and neutral, with financial conditions being accommodating, while independence and transparency in monetary policy remain paramount.

The Federal Reserve is signaling it will be cautious and not follow a preset path in the coming weeks. We should expect policy to be decided on a meeting-by-meeting basis, reacting to incoming data. This uncertainty suggests that being nimble is more important than committing to a long-term directional view.

We just saw the September 2025 Consumer Price Index show core inflation remains sticky at 3.1%, driven largely by services. This aligns with the view that more work is needed to bring inflation down to the 2% target. The labor market also showed signs of cooling, with the last payrolls report adding a modest 150,000 jobs and supporting the idea that risks to employment have increased.

Market Strategies Amid Uncertainty

Given this “particularly uncertain moment,” we should consider strategies that benefit from increased price swings. Expect implied volatility, as measured by the VIX which has been creeping up from its lows earlier in the year, to rise ahead of the next jobs and inflation reports. Looking at options, buying straddles or strangles on major indices could be a way to play the potential for a large move in either direction.

It seems premature to price in aggressive rate cuts, especially after the single quarter-point cut we saw back in July 2025. The commentary suggests a willingness to cut again only if job risks become much more serious. This implies that derivatives tied to short-term interest rates, like SOFR futures, may be overstating the case for imminent easing.

We hear that business contacts feel credit conditions are good, which matches what we’ve seen with credit spreads remaining historically tight for most of 2025. This indicates that widespread stress is not yet appearing in corporate debt markets. Therefore, broad hedges using credit default swaps might be premature right now.

The main tension we face is between that stubborn services inflation and a job market that is cooling but not collapsing. The Fed needs to see more progress on inflation before it will feel comfortable cutting rates again. This means the upcoming Personal Consumption Expenditures (PCE) inflation report will be critical for our positioning into the next FOMC meeting.

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