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Why the Fed May Lower Rates Slower Than Expected Next Year

Oct 27, 2025 01:00:00 -0400 by Nicole Goodkind | #Federal Reserve

Voting members of the Federal Reserve’s board of governors include both inflation hawks and those who say lower rates are essential in today’s economy. (Hu Yousong/Xinhua/Getty Images)

Key Points

Financial markets have already written the script for 2026: The Federal Reserve will deliver a smooth series of interest-rate cuts, bringing relief to investors who have endured the most aggressive tightening cycle in decades.

Futures traders are betting on it. Options markets are pricing it in. Most investors expect interest rates to fall between 2.75% and 3.0% by year-end. That is a full 1.25 percentage points below today’s 4%-4.25% range, according to the CME FedWatch tool.

Wall Street analysts agree. Citigroup sees cuts in December, January, and March as labor markets soften. Pantheon forecasts at least three cuts next year in March, June, and September. Morgan Stanley predicts five, arguing that slowing growth and cooling inflation will force the Fed to jump-start the economy.

There is just one problem. The Fed doesn’t see it that way.

While traders envision a clean downward arc for rates, Fed officials are sketching something messier—slower cuts with long pauses between moves. That gap could mean disappointment for investors and turbulence for financial markets next year.

The numbers tell the story. Policymakers’ median projection in September put rates at 3.4% at the end of 2026, just 0.2 percentage points below their 2025 forecast. That is far from the market’s 2.75%-3% target.

So why the caution? The Fed’s dual mandate of full employment and price stability doesn’t scream emergency. Officials project core inflation at 2.6% next year, above the central bank’s 2% annual target, while unemployment hovers around 4.4%.

A quarter point cut this week is nearly certain, especially after Friday’s delayed September CPI report showed inflation at 3% last month, the BLS reported Friday, below economists’ forecasts for a 3.1% rise with tariff impacts remaining moderate.

The Fed’s projections aggregate individual submissions aren’t considered a consensus forecast. As former Fed economist Claudia Sahm has written, “The medians in the SEP aren’t the Fed forecast and never will be.” Still, it remains the closest thing to a road map of policymakers’ views.

But next year also brings a new cast of characters to the Federal Reserve that could reshape the policy debate entirely.

Jerome Powell’s four-year term as Fed chair expires in May 2026, although he could remain a Fed board member through early 2028. Stephen Miran, one of President Donald Trump’s top economic advisors, joined the Board in September after confirmation by the Senate, filling a term that expires at the end of January 2026. His seat likely will be filled by Trump’s next pick as Fed chair.

The legal battle over Fed governor Lisa Cook adds another layer of uncertainty. Trump has sought to fire her for alleged mortgage fraud, but lower courts blocked attempts to remove her. The Supreme Court has scheduled arguments in January in the case of Trump v. Cook, which allows Cook to remain on the Board for now. The outcome of the legal case may affect the Board’s voting balance next year, and set a precedent about removing Fed governors.

“If forced to reduce the agenda of the Trump administration to one guiding principle, we probably would choose ‘personnel is policy.’ The people appointed to government roles determine how policy is interpreted, implemented, and enforced,” said Vincent Reinhart, chief economist at BNY Investments. “We think that, once formed, the new majority at the center will favor lowering interest rates substantially and quickly,” he added.

“The transformed Fed will keep cutting policy rates next year until the economy and financial markets stop it,” he said. He predicts that would be at a lower bound range of 2 ½%.

But beyond Washington, the regional Federal Reserve Bank presidents become voting members on the Fed’s policy-setting committee on a rotating annual basis. The four Reserve Bank presidents voting next year are the Cleveland Fed’s Beth Hammack, Anna Paulson from Philadelphia, Lorie Logan from Dallas, and Neel Kashkari from Minneapolis. They join the New York Fed president, who votes every year.

This particular mix pairs pragmatists with hawkish officials who have consistently emphasized inflation risks, a combination that argues against any predetermined cutting schedule.

Hammack told the ECB in Frankfurt last month that inflation has stayed above target for 4.5 years. “When I look at the trend, it’s in the wrong direction,” she said. “We need to maintain a restrictive stance of policy to ensure that we can bring inflation back to target.”

Kashkari warned this month that large cuts could stoke inflation. “If you try to drive the economy faster than its potential to grow and its potential to produce prices, you end up just going up across the economy,” he said.

Logan says she’ll “be cautious about further rate cuts.” Delivering 2% inflation, she noted in September, requires “carefully calibrating the stance of policy.”

The economic backdrop for 2026 brings its own set of challenges. Tariffs could still push inflation higher and complicate an easing cycle. Consumer spending, while still robust, is showing signs of easing, which could dent economic growth.

Labor markets are another concern, and further complicate the picture. The U.S. unemployment rate reached 4.3% in August, up from 3.4% in the spring of 2023. Layoffs are up 66% year over year and are the highest year to date since 2020, according to recent data from Challenger, Gray, & Christmas. If that weakness continues, there could be more rate cuts down the line.

Joyce Huang at American Century Investments sees just one cut in 2026. The first half of the year will bring continued slowing, she said, but the second half could reaccelerate on stimulus from Trump’s economic agenda and strong upper-income spending.

“If we get a quarter point cut in October, another in December and one more early in the year, that is three-fourths of a percentage point, which is very close to the terminal rate,” Huang said. “That would take some pressure off the Fed, they have delivered what the president wants in terms of reducing the rate. It would, in our opinion, be a policy rate if they were to cut much more than one time early next year.”

The Fed’s 2026 playbook likely features cutting, pausing, and reassessing and not the steady stream of reductions markets are pricing in. That disconnect will be the story to watch.

Write to Nicole Goodkind at nicole.goodkind@barrons.com.