Q3 2025 Economic Summary

From Hawk to Dove: The Fed’s Q3 Pivot Toward Accommodation

Key Highlights

• The Fed initiated a rate-cutting cycle with an initial 25 basis point cut in September, marking a shift toward a more accommodative policy stance amid signs of labor market softening.
• The US economy has remained remarkably resilient, even as concerns over a cooling job market raised questions about the sustainability of growth momentum.
• Equity markets continued their upward trajectory, with major indices closing the quarter near record highs. The Fed’s dovish pivot contributed to this growth along with strong corporate earnings and ongoing optimism around AI-driven innovation.
• Interest rates covered a wide range throughout the quarter, testing higher yields then briefly visiting the 4% threshold in 10-Year US Treasuries before retracing to within 8 basis points from when the quarter began.

Introduction

The third quarter of 2025 was defined by a mix of economic resilience and policy recalibration. While the U.S. economy continued to show strength, particularly in consumer spending and equity markets, growing concerns around the labor market versus persistent inflation began to shift the narrative. The Federal Reserve, previously in a holding pattern, adopted a more cautious and reactive stance, initiating a long-anticipated rate-cutting cycle with a 25-basis-point reduction in September.

On the policy front, tariff tensions that had escalated earlier in the year began to ease, reducing a key source of uncertainty. Notably, the U.S. reached significant trade agreements with both the European Union and Japan in July, establishing a 15% baseline tariff on most imports. Meanwhile, the signing of the One Big Beautiful Bill Act (OBBBA) on July 4 introduced sweeping changes to tax policy, federal spending, and financial reporting—reverberating across sectors and influencing economic expectations.

Labor market data took a more prominent role in shaping the outlook, as signs of employment cooling became more evident, even though the headline unemployment rate remained within a historically acceptable range. At the same time, inflation remained stubbornly above the Fed’s 2% target, keeping price stability concerns front and center.

These conflicting dynamics —between a softening labor market and sticky inflation —brought the Fed’s dual mandate into sharp focus. In response, the FOMC’s September decision to cut rates marked a pivotal moment, signaling a shift toward supporting growth. However, this move also raised concerns that stimulative policy could reignite inflationary pressures, potentially undermining the progress made since the post-pandemic inflation surge.

The Economy: Q3 Outlook and Q2 Retrospective

Before diving into the economic developments of Q3, it’s important to revisit the evolution of the Q2 GDP forecast. Initial projections for Q2 growth were modest, around 1.5%, likely dampened by the -0.5% contraction in Q1. That decline was largely driven by a surge in consumer and business purchases of foreign goods ahead of anticipated tariffs, following President Trump’s inauguration in January. Since the GDP calculation includes ‘Net Exports’, calculated as exports minus imports, this front-loading of imports negatively impacted Q1 growth

As the summer progressed, Q2 GDP estimates were steadily revised upward, reflecting the resilience of the U.S. consumer, who had been underestimated. The initial July estimate of +3.0% was followed by a second estimate of +3.3% in August, culminating in a final reading of +3.8% in September. This represented the strongest quarterly growth since Q3 2023, defying expectations of continued weakness due to Q1’s performance, tariff-related uncertainty, and subdued investment sentiment.

This unexpected strength has led to a wide range of forecasts for Q3 GDP growth. Estimates span from +1.3% in the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters to +3.8% in the Federal Reserve Bank of Atlanta’s GDPNow model.

The Federal Reserve: Policy Shifts Amid Political Turbulence

In a departure from its traditionally measured and methodical approach, recent developments at the Federal Reserve have taken on an unexpectedly dramatic tone—more reminiscent of a reality television saga than the institution’s usual quiet deliberation. President Trump’s intensifying pressure on the Fed’s monetary policy stance, coupled with his efforts to reshape its leadership, introduced a level of political theater rarely seen in central banking.

At the September FOMC meeting, officials voted to reduce the Federal Funds Target Rate by 25 basis points, bringing it to a range of 4.00% to 4.25%. Alongside this decision, the Committee released its quarterly Summary of Economic Projections (SEP), commonly referred to as the “Dot Plot.” The updated projections reflected a modest downward revision in the implied Fed Funds rate, with the median forecast suggesting two additional rate cuts by year-end—targeting a range of 3.50% to 3.75%. Looking ahead to 2026, the Dot Plot chart below indicates expectations for another 25 basis points cut. However, it’s important to note that long-term rate forecasts, whether from Fed officials or private economists, become increasingly speculative as economic uncertainty and policy assumptions compound over time.

Source: Federal Reserve Board, Bloomberg

What prompted the Fed to shift from a steady, mildly restrictive stance to a more accommodative posture? The answer lies in evolving concerns about the labor market. Prior to the Federal Reserve’s Economic Policy Symposium in Jackson Hole (August 21–23), the prevailing consensus among policymakers was to maintain the existing policy trajectory, despite persistent pressure from President Trump. Chair Powell and the Committee remained committed to their dual mandate, prioritizing inflation control over employment softness.

However, the tone changed significantly at Jackson Hole. Chair Powell’s remarks signaled heightened concern about labor market conditions, suggesting that a September rate cut could mark the beginning of a broader easing cycle. This shift in emphasis, from inflation vigilance to employment support, was a key turning point in the Fed’s policy narrative.

Throughout 2025, tensions between President Trump and the Fed escalated. The President publicly criticized the Committee and demanded aggressive rate cuts, but Chair Powell and his colleagues maintained their commitment to policy independence. In a particularly theatrical moment during a July visit to the Fed’s headquarters renovation project, Trump rebuked Powell for alleged mismanagement and threatened legal action.

In August, Trump attempted to remove Fed Governor Lisa Cook over unresolved mortgage fraud allegations—an issue expected to reach the Supreme Court in January 2026. Following Adriana Kugler’s resignation that same month, Trump appointed Stephen Miran to the Board. Miran, a vocal Fed critic and staunch Trump ally, cast the lone dissenting vote at the September meeting, advocating for a more aggressive 50-basis-point cut.

Inflation: Persistent Pressures and Policy Implications

Inflation remains stubbornly elevated, continuing to challenge the Federal Reserve’s efforts to guide price growth back toward its 2% target. While headline figures have retreated from the pandemic-era peaks, recent data underscores the difficulty in achieving further meaningful progress. Over the past 18 months, key inflation metrics, including the Fed’s preferred measure (core-PCE), have consistently hovered near the 3% mark. The latest readings show core-PCE at 2.90%, core-CPI at 3.1%, and core-PPI at 2.8%, suggesting a plateau in disinflationary momentum.

One complicating factor is the anticipated impact of tariff-related inflation, which has yet to fully materialize in the broader data. While retailers have begun passing along higher input costs in select tariff-sensitive categories, the overall effect on headline inflation remains limited. Notably, as shown below, categories such as Transportation (excluding Motor Fuel) and Household Furnishings & Supplies have seen modest price increases in recent months. However, these gains are likely being offset by continued softening in the shelter component, a key driver of inflation over the past several years.

This dynamic presents a challenge for policymakers, economists, and market participants alike. The Fed must weigh the risk of entrenched inflation against signs of economic cooling, particularly in the labor market. With inflation indicators stalling and tariff effects unevenly distributed, the path forward for monetary policy remains complex and data-dependent.

Source: Bloomberg

The Labor Market: Signs of Softening Amid Political Uncertainty

As noted earlier, growing concerns about a cooling labor market have increasingly shifted the focus of both the Federal Reserve and market participants away from inflation. While the headline unemployment rate remains relatively stable at 4.3%, still within the bounds of what is considered full employment, other indicators suggest emerging weakness beneath the surface.

Evidence of labor market softening began to surface prior to the September Preliminary Benchmark Revision, which significantly adjusted previously reported payroll data. The revision reduced net job gains by 911,000 for the 12-month period ending March 2025, cutting average monthly job growth from approximately 147,000 to just 71,000. This marks the largest downward benchmark revision since 2002, underscoring the fragility of recent labor market momentum.

Compounding these concerns is the impact of the now-active government shutdown, which has already suspended key data releases, including the Nonfarm Payroll report. Historically, such shutdowns have disrupted labor market reporting, but this episode carries additional risks. President Trump has publicly stated that he may choose not to rehire furloughed federal employees once the shutdown is resolved—a departure from precedent that could further strain employment figures and sentiment.

Taken together, these developments suggest a labor market that is losing steam, with potential policy and political implications that could weigh on broader economic performance in the months ahead.

The Consumer: Spending Strength vs. Sentiment Weakness

Given that consumer spending accounts for nearly 70% of U.S. GDP, the health of the American consumer remains the most critical driver of economic growth. Interestingly, while actual spending data continues to show resilience, consumer sentiment surveys paint a more pessimistic picture, highlighting a notable disconnect between behavior and perception.

As illustrated in the chart above, both Headline Retail Sales and the Retail Sales Control Group (which excludes more volatile components such as autos and gasoline) have posted relatively consistent positive monthly gains. This trend suggests steady and sustained consumer activity over the past several years, reinforcing the strength of household consumption.

In contrast, the chart below reflects a more somber mood among consumers. The University of Michigan Consumer Sentiment Index has remained depressed, well below historical averages. Typically, readings near 100 signal broad optimism - associated with strong spending, low unemployment, and stable inflation. Readings closer to 50, however, indicate heightened anxiety about job security, rising prices, and economic uncertainty. These lower sentiment levels often coincide with periods of economic stress. Essentially, the consumer’s perception is one of heightened economic stress versus their actions, which indicate consistent spending patterns.

Source: Bloomberg

Consumer Credit: Rising Delinquencies and Tighter Lending Conditions

Despite some relief from lower borrowing costs, the consumer credit landscape has grown increasingly strained. As illustrated in the chart below, the percentage of loan balances delinquent by more than 90 days has risen across several categories, particularly credit card and auto loans, signaling mounting financial stress among consumers.

A deeper dive into the data confirms this trend. Delinquency rates have climbed in recent quarters, reversing the post-COVID improvement and approaching levels last seen prior to the Great Financial Crisis. Current figures in the chart below show credit card delinquencies at 3.05%, consumer loans at 2.76%, and other consumer loans at 2.40%. While still below crisis-era extremes, the upward trajectory is concerning and reflects the lingering impact of pandemic-era inflation and tighter household budgets.

In response, banks and lenders have maintained restrictive credit conditions, as shown below. These tighter standards disproportionately affect lower-income and subprime borrowers, who face reduced access to credit and higher borrowing costs. Additionally, small and mid-sized businesses, which are more reliant on traditional bank lending, are feeling the pinch, which could dampen investment and growth.

While the broader economy has remained resilient, the persistence of tighter credit conditions may begin to weigh on momentum. The Federal Reserve has acknowledged that these lending constraints have played a role in cooling inflation, effectively complementing the prior period of more restrictive monetary policy without requiring additional rate hikes in the near term.

Interest Rates: Market Stabilization and Structural Constraints

The benchmark 10-Year U.S. Treasury yield continued its downward trend through the third quarter, rebounding off the psychologically significant 4.00% level. Compared to the volatility seen in Q2, particularly following President Trump’s “Liberation Day” tariff announcement, Q3 market activity was notably more orderly, though still marked by underlying uncertainty.

It’s important to remember that the Federal Reserve’s rate-cutting cycle primarily affects short-term interest rates. Longer-term yields, such as the 10-Year Treasury, are additionally influenced by broader factors, including inflation expectations and the term premium, the additional yield investors demand for holding longer-duration securities. With the yield curve returning to a more traditional upward slope and concerns mounting over the expanding federal deficit, the term premium has begun to rise, keeping long-term rates at a higher premium than would otherwise be expected.

President Trump’s persistent calls for the Federal Reserve to cut interest rates to lower long-term yields and stimulate economic growth have drawn considerable attention. However, it’s important to recognize that the relationship between the Fed Funds Target Rate and the 10-Year U.S. Treasury yield is not perfectly correlated. Long-term rates are influenced by a broader set of factors, including inflation expectations, investor sentiment, and the term premium.

A key structural constraint is the Fed’s expected policy path. With the overnight rate projected to remain in the 3.25% to 3.50% range through December 2026, there is a natural floor beneath which long-term yields are unlikely to fall. The 10-Year Treasury is likely to maintain a positive spread over shorter-term debt to preserve an upward-sloping yield curve, which reflects healthy economic expectations and compensates investors for duration risk.

While short-term dips in the 10-Year yield are possible, particularly in response to market volatility or flight-to-safety dynamics, sustained declines would likely require a significant shift in monetary policy or a deterioration in macroeconomic conditions. In the current environment, long-term yields are expected to remain range-bound, with limited downside unless broader economic fundamentals change materially.

Mortgage rates, which closely track the 10-Year U.S. Treasury yield, declined sharply in the third quarter, extending the downward trend that began earlier this year. According to the Bankrate 30-Year Mortgage Rate Index, borrowers were able to secure rates below 6.50%, a level not seen in over two years. This marks a positive development for prospective homebuyers and the broader housing market.

However, affordability remains a significant hurdle. Many homeowners who locked in historically low mortgage rates (some below 3%) during the post-COVID period have little financial incentive to refinance or move, given the higher prevailing rates. This dynamic has contributed to reduced housing turnover and limited inventory, dampening market activity.

To meaningfully stimulate housing demand through borrowing costs alone, interest rates would need to decline further. While recent rate relief is encouraging, it may not be sufficient to overcome the affordability constraints that continue to weigh on the housing sector.

Equity Markets: AI Momentum and Rate Relief Drive Gains

Equity markets continued their upward trajectory in the third quarter, fueled by strong performance in technology and AI-related sectors. The S&P 500 Index reached new highs on a near-weekly basis, culminating in a record close at 6,699 near quarter-end. This steady climb followed the volatility of Q2 and was supported by a more stable macro backdrop and growing optimism around the Federal Reserve’s policy pivot.

Markets responded positively to the Fed’s September rate cut and the expectation of further easing, as investors interpreted the shift as a proactive measure to support the economy amid signs of labor market softening. Lower interest rates are broadly viewed as stimulative for equities, particularly growth-oriented sectors.

Small-cap stocks led the charge in Q3, with the Russell 2000 Index rising +12.0%, outperforming the Nasdaq (+11.2%), S&P 500 (+7.8%), and Dow Jones Industrial Average (+5.2%). This outperformance aligns with my expectations following the Fed’s August pivot at Jackson Hole, as small-cap companies tend to be more sensitive to borrowing costs. Lower rates can significantly improve their ability to manage operations and invest in growth, making them more responsive to accommodative monetary policy.

The Housing Market: Regional Divergence and Structural Challenges

The U.S. housing market remains highly fragmented, with conditions varying significantly not only by region but often by city. While some areas are beginning to show signs of price adjustment, the broader market continues to struggle with affordability and supply constraints, issues that lower interest rates alone are unlikely to resolve.

The core challenge remains a mismatch between supply and demand. A limited inventory of available homes is being met with strong buyer interest, maintaining upward pressure on prices and limiting transaction volume. As shown in the chart below, home sales have remained stagnant for nearly three years, hovering near the lowest levels observed over the past three decades.

Regional trends further highlight the uneven nature of the market. In states like Florida and Texas, both of which saw significant housing booms during the pandemic, prices have begun to retreat, with declines of -3% and -4%, respectively. Austin, a standout during the COVID surge, has experienced a sharp -24% drop. In contrast, the Northeast, particularly the New York City metro area, has continued to see price appreciation, with home values rising nearly +15% since the pandemic, notably from a much higher base, making affordability for the heavily populated area more difficult. Nationally, home prices have increased by approximately +4% over the same period.

While recent declines in mortgage rates offer some relief, they are unlikely to spark a meaningful rebound in housing activity without a broader improvement in affordability and inventory. Structural imbalances in supply and demand will need to be addressed before a sustained recovery can take hold.

Source: Zillow

The Outlook: Steady Growth Amid Uncertainty

The U.S. economy is expected to maintain a steady growth trajectory through the remainder of 2025 and into 2026. Reflecting recent strength, I’ve revised my base-case annualized growth forecast for 2025 upward from +1.5% in the Q2 Outlook to +1.8%. There remains a meaningful possibility of upside surprise, with growth potentially exceeding 2%, though several headwinds could temper momentum.

Key risks include elevated tariffs and ongoing trade policy uncertainty, which may constrain business investment and global demand. Additionally, fiscal tightening from OBBBA spending cuts and the current federal government shutdown could weigh on growth, though the extent and duration of these impacts remain unclear. Other factors, such as tighter credit conditions, persistent housing affordability challenges, and a cooling labor market, also pose as potential drags. Despite these same conditions already existing, the economy demonstrated resilience over the past three months, expanding at an annualized rate of 3.8%.

I continue to anticipate a soft-landing scenario, with recession risks remaining low. However, concerns around stagflation, a combination of slowing job growth and sticky inflation, have emerged and warrant close monitoring.

The Federal Reserve is expected to implement two additional rate cuts before year-end, bringing the Fed Funds Target Rate to a range of 3.50%–3.75%. This marks a significant shift from my earlier expectation for zero cuts in 2025, which I revised following Chair Powell’s remarks at the August Jackson Hole symposium. His comments at the meeting signaled growing concern over labor market softness, leading to my pre-emptive adjustment. I anticipate a pause after the December cut, and possibly two further reductions in 2026 in response to continued labor market weakness. That said, longer-term rate forecasts become increasingly speculative as economic variables evolve.

Interest rates are likely to remain within a relatively narrow band over the next three months. The 10-Year U.S. Treasury yield appears to have a floor near 4.00%, given the expected Fed Funds rate and current inflation dynamics. Conversely, a ceiling near 4.50% seems likely, as market conditions and technical limitations would make it difficult for yields to rise meaningfully above that level. Any sharp moves outside this range, driven by geopolitical or market shocks, should be viewed as tactical trading opportunities rather than structural shifts.

Despite concerns over stretched valuations, I expect the equity market to continue its upward momentum. Any pullback should be viewed as a buying opportunity to deploy capital more aggressively. I maintain a year-end target of 7,000 for the S&P 500 Index, supported by continued economic expansion and accommodative monetary policy. Thus far, economic headwinds have proven to be little more than speed bumps for equity performance, and investors risk missing out by remaining on the sidelines.

An index is unmanaged and not available for direct investment. Definitions sourced from Bloomberg.

The Bloomberg Barclays Global Aggregate Negative Yielding Debt Market Value Index represents the portion of the Bloomberg Barclays Global Aggregate Index that measures the aggregate value of global debt with a negative yield. • The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities and serves as the foundation for a wide range of investment products. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization. • The NASDAQ Composite Index is a broad-based capitalization-weighted index of stocks in all three NASDAQ tiers: Global Select, Global Market and Capital Market. The index was developed with a base level of 100 as of February 5, 1971.• The Cboe Volatility Index® (VIX) is a calculation designed to produce a measure of constant, 30-day expected volatility of the US stock market, derived from real-time, mid-quote prices of weekly S&P 500® Index (SPX) call and put options with a range of 23 to 37 days to expiration.• The ICE BofA MOVE Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options. It is the weighted average of implied volatilities on the CT2 (Current 2 Year Government Note), CT5 (Current 5 Year Government Note), CT10 (Current 10 Year Government Note), and CT30 (Current 30 Year Government Note), with weights 0.2/0.2/0.4/0.2 respectively.• The Markit CDX North America Investment Grade Index is composed of 125 equally weighted credit default swaps on investment grade entities, distributed among 6 sub-indices: High Volatility, Consumer, Energy, Financial, Industrial, and Technology, Media & Tele-communications. Markit CDX indices roll every 6 months in March & September. • The Markit CDX North America High Yield Index is composed of 100 non-investment grade entities, distributed among 2 sub-indices: B, BB. All entities are domiciled in North America. Markit CDX indices roll every 6 months in March & September. • The U.S. Dollar Index (USDX) indicates the general international value of the USD. The USDX does this by averaging the exchange rates between the USD and major world currencies. Intercontinental Exchange (ICE) US computes this by using the rates supplied by some 500 banks.

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