The Great Risk of 2026 – The Fed
Gary Dugan, Michael Chu and Bill O'Neill
The Global CIO Office
- A three way split at the Fed does not bode well for next year
- Dot plot looks like a Christmas tree
- Lack of building consensus and politicisation does not help
- The middle path suggest more rate cuts next year – for political reason that may be right…. but it doesnt mean it is right
The final Fed meeting of the year reinforced investors’ fears that the US central bank will play a pivotal role in shaping the mood of the financial markets in 2026.
Fed monetary policy has at times been contested and politicised, but those challenges have rarely occurred against such a backdrop of erratic, consequential government policy, missing economic data, and a federal debt approaching 120% of GDP. The Fed’s task, as always, is cut out.
The final FOMC meeting of 2025 delivered a further 25-basis-point rate cut, as was widely expected. The target range for the federal funds rate currently stands at 3.50–3.75%, down from a peak of 5.25–5.50% in 2023, moving monetary policy out of clearly restrictive territory.
Chart 1: Fed Funds (%)
Source: Bloomberg
Inflation has continued to slow, supporting the Fed’s case for easing, but it remains above the central bank’s target. Core PCE, the Fed’s preferred measure of inflation, is running around 2.6–2.7%, while headline inflation is hovering near 2.4–2.5%, with the real policy rate roughly at +1%. In real terms, policy is no longer tight; it is at best mildly restrictive.
Unemployment remains around 4.3%, only modestly above cycle lows and well below levels that have historically triggered sustained easing cycles. Growth has slowed but not stalled, with real GDP tracking close to 1.8–2.0%. Financial conditions have eased, equity markets are strong, and credit spreads remain contained.
That is the backdrop against which the Fed is debating what comes next.
Signals from the Latest Fed Meeting
The December meeting made it clear that the Committee is now split less over whether to cut and more over how far to go in 2026.
The dot plot indicates further easing, with the median projection implying 50–75 bps of additional cuts over the course of 2026. However, dispersion is wide. Several participants see rates stabilising near current levels, while others are comfortable taking the policy rate closer to 3%.
Chart 2: Fed Dot Plot Shows Little Consensus
Source: Bloomberg
The voting pattern reflected this conflict. A minority favoured holding rates steady, arguing that with inflation still above target and unemployment low, the bar for further easing should be high. Others, however, pointed to the lagged effects of past tightening and the risk that policy could become inadvertently restrictive as inflation falls.
While the differing voices aren’t unusual, what stands out this time is that this debate is taking place without the usual catalysts. Historically, the Fed has cut rates aggressively when unemployment has risen sharply, financial stress has been evident, or recession risks have been acute. None of those conditions clearly apply today.
Over the past 50 years, the Fed has rarely eased policy meaningfully when unemployment is near 4%, unless something was already breaking. That remains the key anomaly.
Real Rates, Real Ambiguity
Much of the current confusion stems from the real-rate picture. With inflation decreasing faster than nominal rates, real policy settings have loosened materially. At about +1%, real rates are no longer doing the heavy lifting.
Yet the economy has not weakened materially. Wage growth remains near 4%, consumption is holding up, and fiscal policy continues to provide support. The traditional transmission from lower real rates to accelerating growth has not been particularly strong, nor has the lagged drag from earlier tightening been especially painful.
This leaves the Fed in a tricky position. Cutting rates further risks overstimulating an economy that is not clearly fragile. It should also be noted that fiscal policy will deliver a net stimulus to the economy in the first quarter of 2026 as the tax cuts take effect. Talk of further, early rate cuts in 2026 to us seems wide of the mark, unless politics plays a big role in such a decision.
2026 and the Question of Leadership
The Fed policy uncertainty we see today coincides with one of the most politicised leadership changes in decades. The current Fed Chair’s term ends in early 2026, and recent public remarks from President Trump have focused attention on two names: Kevin Warsh and Kevin Hassett. Markets will interpret this choice as a signal of the Fed’s future reaction function.
Warsh is the institutional candidate. A former Fed governor whose term coincided with the Global Financial Crisis, he understands market plumbing, crisis management, and the importance of credibility. Since leaving the Fed, Warsh has been openly critical of prolonged QE and ultra-low rates, arguing that they distort capital allocation and contribute to later inflation. Markets would likely interpret a Warsh appointment as reinforcing discipline and institutional independence. Further cuts could still occur, but they would be seen as conditional rather than automatic.
Hassett signals a different approach. As a former Chair of the Council of Economic Advisers, his background is in growth-oriented policy rather than central banking. He has been more comfortable arguing that monetary policy can be overly tight even when inflation is above target, particularly if growth or employment are at risk. Markets would likely view a Hassett appointment as increasing the risk that policy becomes more responsive to political and fiscal pressures.
The distinction matters less for maybe the first 25-bp move and more for longer-term expectations around inflation tolerance, balance-sheet policy, and independence.
Debt, Deficits, and the Quiet Constraint
Structural challenges posed by the scale of the Federal debt at roughly $35 trillion, which is close to 120% of GDP, continue to worry markets. Net interest costs are approaching $1 trillion per year, making them one of the fastest-growing components of federal spending. As low-coupon government debt issued during the pandemic years continues to roll off, the budget’s sensitivity to interest rates remains high.
This creates a subtle but persistent pressure on monetary policy. Lower rates ease fiscal arithmetic over time. That does not mean the Fed is explicitly targeting debt sustainability, but markets are alert to the risk that fiscal policy will become an increasingly significant challenge for debt sustainability in the US.
If investors begin to believe that rate cuts are being driven by debt-servicing concerns rather than by inflation dynamics, the response will not be confined to the policy rate. Term premia would rise, and the benefits of easier policy could be diluted by a steepening yield curve.
Implications for Bonds and the Dollar
If the hand of the presidency pushes for further easing in 2026, particularly if it takes rates towards 3%, it is unlikely to produce the bond rally that many expect. With inflation still above target and fiscal supply heavy, long-dated yields may remain elevated even as the front end moves lower.
Mortgage rates, currently still above 6.5%, may not fall materially. Foreign demand for Treasuries could soften if real returns are perceived to be capped or policy credibility questioned.
The dollar remains supported by liquidity and institutional depth, but neither is an unconditional pillar of support. Confidence in the Fed’s independence matters as much as interest-rate differentials. Any perception that the Fed’s reaction function has shifted materially would be reflected first in long-dated bonds and then in a potential weakening of the dollar.
No Comfortable Historical Guide
There is no clean precedent for the current setup: policy rates in the mid-3s, unemployment near 4%, inflation above target, and debt at post-war highs. The 1970s comparison does not fit. The post-GFC period is not relevant. Even emerging-market analogies fall short given the dollar’s reserve role.
The absence of a historical template raises the risk of policy error.
What This Means for Investors
Assumptions of a smooth, extended easing cycle in 2026 look optimistic. The starting point matters. Real rates are no longer tight. Labour markets remain resilient. Fiscal policy is expansionary. Debt constraints are real.
Duration risk, particularly at the very long end, will need careful management by the Treasury. Portfolio currency exposure matters more now than it has been in years. Assets that hedge policy credibility risk, including gold, remain strategically very relevant. Equity markets may continue to perform, but leadership is likely to be narrower and more volatile than in the early phase of easing. We continue to advocate for Asian markets, such as Japan and Korea, which are supported by favourable valuations and structural change. Both China and India should benefit from ongoing good growth.
Portfolio diversification needs to be genuine. Correlations can change quickly when the credibility of government and central bank policy is questioned.
Final Thought
The Fed enters 2026 having already cut rates substantially, yet without the usual economic justification for doing much more. The next phase of policy will be shaped less by inflation prints and more by credibility, leadership, and perception. Markets should be prepared for a wider range of outcomes than they have grown accustomed to. Precision in market forecasts will matter less than maintaining resilience in portfolios.
