With inflation cooling and the labor market showing cracks, the Fed is in a tricky spot. Here's my read on what Powell and company are likely planning for the next six months.

We've come a long way from the 9.1% inflation peak. The latest CPI reading came in at 3.7%, and more importantly, the trend is heading in the right direction. Core inflation is sticky but gradually declining. The labor market, while still strong, is showing clear signs of cooling.

The CME FedWatch tool currently shows a 65% probability of a rate cut by March 2026. That feels about right to me. The Fed has been signaling a higher-for-longer approach, but the data is starting to force their hand.

Here's what I'm watching closely. First, the employment numbers. The unemployment rate has ticked up to 3.9% from 3.4% earlier this year. That's still historically low, but the direction matters more than the level. Second, wage growth is moderating, which takes pressure off services inflation. Third, the housing market has essentially frozen up, which will eventually show up in shelter inflation data.

My base case is three to four rate cuts in 2025, each 25 basis points, bringing the federal funds rate down to around 4.5-4.75% by year end. That would still be restrictive by historical standards, but less punishing than current levels.

For equity investors, this is generally good news. Lower rates reduce the discount rate on future cash flows, which particularly benefits growth stocks and high-multiple tech companies. Small caps tend to outperform in rate-cutting cycles because they're more dependent on bank lending.

The sectors I like in this environment are technology, real estate, and consumer discretionary. These are the most rate-sensitive areas of the market. I'd be cautious on financials, particularly banks, as rate cuts compress net interest margins.

One risk scenario to consider is that the Fed cuts too early and inflation reignites. That would force them to reverse course, which would be terrible for markets. But right now, that doesn't look like the most likely outcome.