Fed cuts likely to fire up inflation in 2026
We fear that easing monetary policy at this stage of the cycle may prove counterproductive.
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The Federal Reserve’s (Fed) decision to press ahead with interest rate cuts at a time when the solid real economy is close to full employment raises the risk of higher inflation becoming ingrained. We now think that the Fed will deliver another two 25bps cuts by the end of 2025. But rates are unlikely to fall further thereafter as robust growth drives a rebound in labour market activity and causes inflation to rise. As such, we continue to believe that market pricing for a terminal rate of below 3% is far too aggressive.
We are surprised the Fed is easing at all. In our last global forecast update we reasoned that as the tariff and fiscal fog cleared, a rebound in activity and hiring would stay the Fed’s hand. But while the broader economy has indeed picked up – something acknowledged by the Fed’s upward revision to its own growth forecast – payroll growth has slowed in recent months. We put that down to a combination of lagged labour market dynamics and the administration’s clampdown on immigration. Chair Powell had a different interpretation at Jackson Hole, warning that “the balance of risks appears to be shifting”.
His comments at the September meeting press conference continued to highlight that while inflation “remains somewhat elevated”, economic growth has “moderated” and “job gains have slowed”. This, along with the signal from the latest dot plot, mean we now expect the Fed to cut rates by 25bps at its next two meetings to 3.75%.
However, we remain concerned that easing policy at this stage of the cycle will prove counterproductive. Indeed, the backdrop is hardly one that screams for stimulus. Equities are at record highs, credit spreads are very tight, and the economy is already running above potential at a time when fiscal policy is set to add more fuel in the months ahead. In this environment, rate cuts are more likely to stoke inflation than real growth. We’ve nudged our 2026 US GDP growth forecast up only modestly – from 2.2% to 2.3% – but lifted our inflation forecast more meaningfully to a consensus-busting 3.3%.
Looking further ahead, there’s a material risk inflation becomes unanchored. Structural constraints – especially a shrinking labour supply – mean the economy’s potential growth rate is falling. That raises the odds of a tighter labour market, faster wage growth, and stickier inflation. Long-dated bonds won’t like that, especially given the already troubling debt dynamics.
Globally, stronger US demand should be a tailwind. With trade risks receding and global manufacturing indicators turning up, we’ve revised up our ex-US growth forecasts too. But unlike the US, the impulse abroad should skew more towards real growth than inflation. Ironically, despite the Trump administration’s best efforts to re-shore demand, the rest of the world may end up the biggest winners from its stimulus push.
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