Fed's Rate Cut Conundrum: An Outlook to 2026

Article Highlights

• The Fed is contemplating another rate cut this month due to a weakening labor market.
• Divergent views within the Fed regarding the need for further cuts due to inflation concerns.
• Uncertainty surrounds the trajectory of interest rates through 2026 amid conflicting economic data.
• Powell's warnings about the labor market underscore the need for rate cuts.
• Persistent inflation poses a challenge to further rate cuts.
• Potential changes in Fed leadership could influence monetary policy.

The Fed at a Crossroads

The Federal Reserve (Fed) appears poised to implement another interest rate cut this month. This shift reflects a growing concern about a noticeably slowing labor market, making it a more pressing issue than inflation worries. However, this delicate balance might not hold for long. Within the Fed's ranks, voices are calling for caution, pointing out that price levels have remained above the target for many years and still face upward pressure. Even some policymakers who have expressed openness to two more rate cuts this year lack confidence in extending that trajectory further.

Uncertainty Clouds the Future

All of this implies that the path of borrowing costs the Fed will take through 2026 is far more uncertain than the financial markets' current expectations of a steady, gradual decline. Economic data adds to the confusion, pointing in different directions: resilient growth and consumer spending, while hiring is slowing. The government shutdown, which froze the release of a series of critical data, only exacerbated the situation. And weekly comments from Fed officials are turning into an increasingly heated debate.

Powell's Labor Market Warnings

The task of unifying these divergent positions falls to Fed Chair Jerome Powell. He stated that delaying action carries risks, signaling that the Fed will cut interest rates at its next meeting on October 29. Weak job growth over the past few months, coupled with significant downward revisions to earlier data, has undermined the widely held belief that the U.S. labor market is strong and healthy. Powell describes the U.S. economy as now being in a state of "low hiring, low firing," with no clear signs of widespread layoffs. He warns that this balance may be fragile.

Inflation Looms

James Bullard, former president of the Federal Reserve Bank of St. Louis, says things could get more complicated after that. While an October rate cut seems almost certain, he believes that persistent high inflation and robust growth could jeopardize any additional cuts in December. Some within the Fed believe that there is enough reason to predict no further interest rate cuts next year, especially with ongoing threats related to tariffs, as clearly demonstrated by the latest trade disputes.

Leadership Changes

Adding to the difficulty of predicting the path of interest rates next year are potential changes in Fed leadership and the US economy. Powell's term as chair ends next May. President Trump has stated that he will choose a successor committed to lowering borrowing costs and has sought other ways to push the Fed in that direction. Additionally, Cleveland Fed President Loretta Mester and Dallas Fed President Robert Kaplan, both hawks who have expressed caution about further interest rate cuts, will replace two regional Fed presidents who will gain voting rights next year. Stephanie Roth, chief economist at Wolfe Research LLC, believes that the balance between employment and inflation risks will shape discussions related to the Fed's monetary policy in 2026, which could lead to more cautious action than investors currently expect. She concludes: "The amount of cuts the Fed will eventually make is likely to be less than what the market is pricing in. This may be realized in early next year, with the economy continuing to run a bit too hot."