Federal Reserve Bank of St. Louis President Alberto Musalem spoke about the US economy and monetary policy, emphasizing the high inflation rates and possible weaknesses in the labor market. He noted that successful monetary policy relies on stable inflation expectations, which have recently risen over the last two years. The Fed faces hurdles that limit their ability to quickly respond to short-term changes in the labor market, especially if inflation expectations fluctuate. Currently, only 10% of the inflation we see can be tied to tariffs, which are expected to decline by mid-2026. Musalem anticipates a gradual weakening in the labor market, while GDP growth will likely match its potential this year.

Material Risks Indicating Possible Further Inflation Increases

There are notable risks around baseline expectations, suggesting that further inflation and labor market weaknesses may occur. Q4 GDP is expected to remain stable, but monetary policy needs to tackle inflation. Musalem pointed out that there is limited room for easing due to the risk of being too accommodating, although he is open to a future rate cut for added safety. Current financial conditions are supportive, reflecting ongoing considerations in monetary strategy. The Federal Reserve’s goals of stable prices and maximum employment conflict with each other, creating significant uncertainty. This means that monetary policy could shift based on whether inflation or labor data is worse in upcoming reports. Traders should prepare for potential increased market volatility. The latest Consumer Price Index (CPI) report for September 2025 showed a persistent 3.8%, still far from the 2% target and raising concerns about ongoing inflation. At the same time, last week’s initial jobless claims rose to 235,000, the highest in four months, indicating that the labor market is softening as expected. This data perfectly illustrates the delicate balance the Fed is trying to maintain.

Given This Conflict, Outright Directional Bets on Interest Rates Are Risky

Because of this conflict, making outright bets on interest rates is risky. Instead, it’s better to use derivative strategies that can profit from price changes. Long straddles or strangles on SOFR futures could be beneficial if the next major data release pushes the Fed to make a decisive move. In this environment, implied volatility seems underpriced across asset classes. We believe buying options is more appealing than selling them because the risk of a sudden policy shift is high. The Volatility Index (VIX) has already reflected this change, climbing to 22 last week after staying in the mid-teens for much of the third quarter. We saw a similar situation in late 2024 when mixed signals about inflation and growth led to sharp, erratic trading in equity index futures. Those who hedged their positions with S&P 500 options managed the volatility much better than those without hedges. History shows that caution is wise when the Fed appears uncertain. The direction of the dollar is also uncertain, making currency options on pairs like EUR/USD and USD/JPY particularly valuable. While the Fed is pushing against inflation, the chance of a rate cut to support the labor market complicates the outlook. This is different from the European Central Bank, which has more clearly indicated a pause, leading to a policy divergence that could cause currency fluctuations. Financial conditions remain supportive, suggesting that the market isn’t yet prepared for a significant downturn or a much more aggressive Fed. This indicates potential for repricing in the upcoming weeks. Keep a close eye on upcoming employment and inflation data, as any major surprises could lead to significant market reactions. Create your live VT Markets account and start trading now.

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