Last week’s upside surprise in payrolls underscored the resilience of the labor market despite growing concerns that AI-driven productivity gains could weaken hiring. The strength in the most recent labor readings also significantly increased the likelihood of a September rate hike. Inflation has made meaningful progress, but it remains above target, and a still-solid labor market gives the Fed room to lean a bit further against lingering price pressures.

However, the math looks different today than it did when the Fed embarked on its prior hiking cycle in March 2022. At the peak, headline and core PCE inflation reached 7.2% and 5.6%, respectively, while the fed funds rate was near zero. Inflation exceeded its 2% target by several percentage points, leaving the Fed well behind the curve and forcing markets to reprice aggressively.

Today, headline and core PCE inflation are running at 3.7% and 3.3%, respectively, while the policy rate sits at 3.5% to 3.75%. The gap between inflation and the Fed’s 2% target is much smaller than it was several years ago. Current pricing implies only a modest amount of additional tightening to keep policy sufficiently restrictive, rather than the aggressive adjustment that was necessary when inflation first surged.

For this reason, bond yields could drift modestly higher as the FOMC embarks on another hiking cycle to reinforce its commitment to price stability. However, absent an external shock, we do not see much scope for a sharp move higher in longer-term Treasury yields. In fact, a September hike could ultimately support the long end of the curve, particularly when combined with Fed buybacks. By continuing to signal its commitment to returning inflation to target, the Fed reinforces its credibility and helps anchor long-term inflation expectations. This dynamic can reduce the inflation risk premium embedded in long-duration bonds and place downward pressure on longer-term yields.