The Federal Reserve has introduced a new policy that focuses on flexible inflation targeting. This marks a departure from its previous ‘makeup’ inflation strategy. The goal of this new approach is to help the Fed manage conflicts between its objectives while keeping inflation expectations stable over time.

Policy Adaptation Strategy

The new framework removes specific economic conditions and emphasizes the Fed’s readiness to adjust to different situations. It indicates that the Fed may not need to change policies based only on uncertain employment estimates exceeding their sustainable level. However, if a tight labor market threatens price stability, preemptive actions may be required. Recent data shows that US PCE inflation for the past year increased to 2.6% in July, with core inflation reaching 2.9%. The Fed recognizes that tariffs could raise prices, but these effects are likely temporary. Additionally, GDP growth has slowed because consumer spending has decreased, and strict immigration policies have limited workforce growth. Despite these issues, the unemployment rate remains stable, giving the Fed the flexibility to evaluate potential policy changes carefully. Market expectations currently suggest a 90% chance of an interest rate cut in September, with possibly two cuts by the end of the year. US stock indices have reacted positively, as the Dow, S&P, and NASDAQ have all gained over 1%. The Fed’s shift in focus is clear: it is now more concerned about a weakening labor market and slowing growth rather than just inflation. This new framework allows for rate cuts even if core inflation stays at 2.9%, which is above their target. The main point is that concerns about employment now outweigh concerns about inflation, making a policy adjustment more likely.

Market Strategy Under A Dovish Fed

With the market already pricing in a 90% chance of a rate cut in September, the straightforward trade of buying September SOFR futures is popular. Instead, we should consider positions that expect a longer period of rate cuts, like buying December or March 2026 futures contracts. This strategy assumes that the two cuts anticipated for this year may not be enough to address rising employment risks. The Fed’s stance is encouraging for equity markets. A similar response occurred after the Fed shifted to a dovish approach in early 2019, leading to a sustained rally in the S&P 500 for the rest of that year. Traders might want to buy call options on the S&P 500 or Nasdaq 100 that expire in the fourth quarter. This would allow them to benefit from an increase in stock valuations as lower rates become more likely. Powell’s cautious wording is also meant to reduce market volatility, which has increased recently with the VIX around 17. Selling volatility—through strategies like VIX call spreads or buying put options on the VIX—could be a smart move. If the Fed starts easing without an immediate crisis, we may see the VIX drop back toward the 12-14 range we experienced earlier this year. A more dovish Fed could weaken the US dollar, which has remained strong throughout most of 2025. As rate gaps narrow compared to currencies like the Euro and Yen, shorting the US Dollar Index (DXY) via futures might be wise. Following its recent rise to 105.50, the dollar may be due for a downward shift as expectations of rate cuts strengthen. Create your live VT Markets account and start trading now.

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