Will The Fed Cut Rates This Year?
Inflation fears have dramatically shifted investor sentiment
After months of expecting the Federal Reserve Board to cut interest rates this year, investors have returned to a familiar refrain: “Higher for longer.”
The market today expects the federal funds rate—the Fed’s influential short-term interest rate—to finish 2026 at 3.73%, at the high end of its current target range of 3.50% to 3.75% (see the chart). That 3.73% represents a sharp jump of almost 70 basis points from just a month ago, when investors anticipated a series of three Fed rate cuts that would take the fed funds rate down to 3.05% by year-end.
The obvious culprit: Fears of rising and persistent inflation in the wake of the war with Iran, which has effectively cut off the roughly 20% of the world’s oil supply that comes from the Persian Gulf region, and which could prevent the Fed from cutting rates.
That war-fueled shift in investor sentiment has been the main force behind rising yields on both the 2-year Treasury note (up nearly 50 basis points since late February) and the 10-year Treasury note (up more than 40 basis points). Last week, commentary from other central banks in England, Europe, and Japan reflected this sentiment, putting upward pressure on global rates. Meanwhile, the Fed held its rate outlook steady in the dot plot and the Summary of Economic Projections (SEP), with a median December fed funds projection of 3.4%—implying just one cut in 2026. The market, though, wasn’t buying it.
The good news: While investors are pricing in extreme uncertainty about the future prospects for inflation, they appear to be far less concerned about economic growth at this point, as evidenced by the fact that longer-term bond yields haven’t fallen significantly. This would be expected with a slow-growth outlook. The Fed, too, increased its growth expectations, citing higher AI-driven productivity and a strong consumer.
Ultimately, the Fed finds itself in a tough place, given that inflation had not yet reached the Fed’s desired 2% target before the current oil price shock. Add labor market uncertainty to the mix, and the likely result is that Fed policy will be even more dependent than usual on each new data point that gets released. That may mean greater interest rate volatility for the time being, which in turn may hurt various market segments (mortgage rates and housing, for example) and overall investor sentiment.
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