Federal Reserve 2026: Mapping the Rate-Cut Path and What It Means for Markets

The Federal Reserve began cutting rates in September 2024 from a cycle peak of 5.50 percent, the highest level since 2001. By February 2026, the federal funds rate stands at 4.00 percent after 150 basis points of cumulative easing delivered across six meetings. The pace has been deliberate: three consecutive 25-basis-point cuts in late 2024, a pause in January 2025, and three more 25-basis-point cuts through 2025.

This easing cycle is unusual in several respects. The economy has not entered recession — GDP grew 2.3 percent in 2025, above trend. Unemployment has risen only modestly to 3.9 percent from a trough of 3.4 percent. Financial conditions remain accommodative: the S&P 500 is near all-time highs, credit spreads are tight, and housing prices have stabilised after the 2023 correction.

The Fed is cutting not because the economy is breaking, but because it believes real interest rates (the policy rate minus inflation) are restrictive enough to justify gradual normalisation. With core PCE inflation at 2.6 percent and the nominal rate at 4.0 percent, the real rate is approximately 1.4 percent — still above the Fed’s estimated neutral real rate of 0.5–1.0 percent.

Core Personal Consumption Expenditures (PCE) inflation — the Fed’s preferred measure — has fallen from 5.6 percent in early 2022 to 2.6 percent in January 2026. The disinflation has been driven primarily by goods prices (which are now deflationary at -1.2 percent year-over-year) and a normalisation of supply chains.

Services inflation, however, remains sticky at 3.8 percent. The largest component is shelter (owners’ equivalent rent), which is declining but slowly: new lease rents have fallen 3 percent year-over-year, but the BLS methodology catches this with a 12–18 month lag. The Fed expects shelter inflation to converge toward 2 percent by late 2026 as the lag effect flows through, which would mechanically pull core PCE to 2.2–2.3 percent.

The risk is that non-shelter services inflation — healthcare, insurance, financial services — proves more persistent. These categories are driven by wage growth, which is running at 4.1 percent year-over-year (measured by the Employment Cost Index). While 4 percent wage growth is compatible with 2 percent inflation if productivity grows at 2 percent, US productivity growth has averaged only 1.4 percent over the past decade, suggesting that wages may need to decelerate further to hit the inflation target sustainably.

Fed Chair Jerome Powell has repeatedly stated that ‘we do not need to see inflation at 2 percent to cut rates — we need to see inflation moving convincingly toward 2 percent.’ By this standard, the conditions for further cuts remain in place, but the pace will be slow and data-dependent.

The most consequential question in macro finance is: where does the Fed stop cutting? The ‘terminal rate’ — the level at which monetary policy is neither restrictive nor stimulative — determines the pricing of every financial asset from Treasuries to equities to housing.

The Fed’s own Summary of Economic Projections (SEP) estimates the longer-run neutral rate at 3.0 percent, up from 2.5 percent in 2023. This revision reflects the belief that structural factors — higher government deficits, energy transition capex, AI investment, and demographics — have increased the economy’s equilibrium interest rate.

Market pricing (embedded in the federal funds futures curve) implies a terminal rate of 3.25–3.50 percent, reached by Q1 2027. This suggests two to three more 25-basis-point cuts in 2026, with the bulk occurring in the second half of the year.

The distribution of outcomes is wide. If inflation re-accelerates above 3 percent (due to tariffs, commodity shocks, or fiscal expansion), the Fed could pause or even reverse course. If the labour market weakens more sharply (recession scenario), the Fed could cut aggressively to 2.5–3.0 percent. The base case of gradual normalisation to 3.25–3.50 percent assumes a soft landing that, while achievable, has rarely been accomplished in Fed history.

The Fed’s easing cycle has reshaped the yield curve. The 2-year Treasury yield has fallen from 5.1 percent (October 2023 peak) to 3.65 percent, while the 10-year has declined more modestly from 5.0 percent to 4.2 percent. The curve has steepened from an inversion of -108 basis points to a normal spread of +55 basis points, signalling that bond markets believe the recession risk has passed.

For bond investors, the current environment is constructive but not euphoric. Total returns on the Bloomberg US Aggregate Bond Index were 4.8 percent in 2025, the first positive year after three consecutive losses (2021–2023). The carry on intermediate-duration bonds (4–5 percent yields) provides reasonable compensation, but further capital gains require rates to fall below current levels, which depends on the terminal rate question.

Credit markets are pricing near-perfection. Investment-grade spreads are at 85 basis points over Treasuries, the tightest since 2005. High-yield spreads are at 290 basis points, well below the 10-year average of 440 basis points. The risk-reward in credit is asymmetric: spreads have limited room to tighten but significant room to widen if the economy slows.

Equity markets have historically performed well during Fed easing cycles, and 2025-2026 has been no exception. The S&P 500 returned 17.1 percent in 2025 and is up 4 percent year-to-date in 2026. However, the composition of returns matters: the Magnificent 7 tech stocks contributed 65 percent of the S&P 500’s 2025 gains, raising concentration risk concerns.

Rate cuts benefit equities through three channels: (1) lower discount rates increase the present value of future earnings; (2) reduced borrowing costs support corporate investment and buybacks; (3) the ‘wealth effect’ from rising asset prices supports consumer spending. The question is how much of this is already priced in at 21x forward earnings.

Historically, the S&P 500 trades at an average of 17.5x forward earnings when 10-year yields are 4.0–4.5 percent. Today’s multiple of 21x implies either that earnings growth will be exceptional (consensus is 12 percent in 2026, slightly above trend) or that the market is pricing a lower terminal rate than the Fed’s dot plot suggests. Both assumptions carry risk.

The sectors most sensitive to the rate path are: real estate (REITs benefit directly from lower rates), utilities (dividend proxies re-rate upward), small caps (Russell 2000 companies have higher floating-rate debt), and financials (banks benefit from steeper yield curves but face NIM compression on the short end).

Four data points will determine the Fed’s path for the remainder of 2026:

1. Core PCE inflation (monthly). The Fed needs to see three consecutive prints at or below 0.2 percent month-over-month (annualising to 2.4 percent) to maintain its easing bias. Any print at 0.3 percent or above would trigger ‘patience’ language in the FOMC statement.

2. Non-farm payrolls (monthly). The ‘Goldilocks’ range for the Fed is 100,000–200,000 jobs per month. Below 100,000 raises recession fears and accelerates cuts. Above 200,000 suggests the economy is running too hot and inflation risks are rising.

3. Unemployment rate (monthly). The ‘Sahm Rule’ recession indicator triggers when the 3-month moving average of unemployment rises 0.5 percentage points above the 12-month low. The current reading is 0.3 — close to but below the trigger. A move above 0.5 would dramatically change the Fed’s reaction function.

4. University of Michigan inflation expectations (monthly). The Fed is hyper-sensitive to long-term inflation expectations becoming ‘unanchored.’ The 5-year expectation is currently 3.0 percent, at the high end of the post-GFC range. A move above 3.3 percent would be alarming.