Bank of America expresses concern about inflation remaining above target due to recent tariff hikes. It advises the Federal Reserve to resist cutting interest rates in September, as current economic data does not support easing.
The bank’s note to clients points out that some policymakers may be underestimating the impact of a labour supply shock. Inflation persistence and recent tariff impacts may pose a continued threat, with inflation still above the Fed’s 2% target.
Bank Cautions Against Rate Cuts
Bank of America cautions that reducing rates in September might begin an easing cycle without clear evidence that inflation has peaked. It maintains that no rate reductions are expected this year.
The bank highlights the downward revision of US nonfarm payrolls. This revision raises concerns about potential “bad cuts,” which could occur if the labour market deteriorates instead of achieving inflation control.
We are concerned that inflation is proving more persistent than many anticipate, with the July 2025 Consumer Price Index coming in at 3.1%, still well above the 2% target. The recent tariff hikes announced last month on imported electronics and industrial components present a new and significant inflationary shock. These factors challenge the view that the Federal Reserve has room to ease its policy.
The central bank should resist the urge to lower interest rates at its September meeting. The downward revision of the June nonfarm payrolls data, from an initial report of 190,000 to just 150,000, raises the risk of “bad cuts” made out of concern for the labor market rather than confidence in conquering inflation. We believe policymakers who are pushing for rate cuts are underestimating how stubborn pricing pressures will be.
Market Implications and Strategies
For derivatives traders, this means the market may be mispricing the path of monetary policy. The CME FedWatch tool currently shows a 60% probability of a rate cut in September, which we see as overly optimistic. Positions that benefit from rates staying higher for longer, such as selling September SOFR futures or buying payer swaptions, should be considered.
This policy uncertainty is likely to fuel market volatility. We saw similar spikes in the VIX back in 2022 when the Fed was forced to be more aggressive than the market had initially priced in. Acquiring VIX call options or futures for September and October could serve as an effective hedge against a hawkish surprise from the Fed.
If the Fed holds rates steady in September, it will likely disappoint equity markets that have priced in a pivot to easing. Therefore, a cautious stance is warranted, and traders might look at buying protective put options on the S&P 500. This strategy would hedge portfolios against a potential market downturn driven by the reappraisal of the interest rate outlook.
Furthermore, a hawkish Federal Reserve, especially while the European Central Bank continues to signal a more dovish stance, points toward a stronger U.S. dollar. This makes long positions on the dollar attractive. Derivative plays on a rising USD/EUR exchange rate could offer a compelling opportunity over the next several weeks.
