Assessing the Fed's Policy Path in 2026: What December CPI Hints About Rate Cuts

The Federal Reserve's December 2025 policy decision-a 25-basis-point rate cut-marked a pivotal shift in its approach to inflation and economic growth. This move, coupled with the latest Consumer Price Index (CPI) data, offers critical clues about the central bank's likely trajectory in 2026 and its implications for equity and fixed-income markets.

According to the U.S. Bureau of Labor Statistics, the CPI for All Urban Consumers (CPI-U) rose 0.3 percent in December 2025, with a year-over-year increase of 2.7 percent. Core CPI, which excludes volatile food and energy, edged up 0.2 percent monthly and 2.6 percent annually. These figures, while still above the Fed's 2 percent target, signaled a moderation in inflationary pressures compared to earlier in the year. Shelter costs, a major driver of the index, climbed 0.4 percent, underscoring the persistent stickiness of housing-related inflation. Meanwhile, energy prices saw mixed results: natural gas surged 4.4 percent, while gasoline fell 0.5 percent.

The Federal Open Market Committee (FOMC) responded to this data by reducing the federal funds rate to a range of 3.50–3.75 percent. The policy statement emphasized a "data-dependent" approach, acknowledging that inflation remains "somewhat elevated" but showing "signs of moderation." The FOMC's updated Summary of Economic Projections now anticipates one rate cut in 2026, reflecting uncertainties around inflation and the labor market. Atlanta Fed President Raphael Bostic highlighted that "price stability remains the most pressing risk", even as labor market dynamics evolve.

For equity markets, the December CPI release and subsequent rate cut were met with cautious optimism. The S&P 500 edged up 0.1 percent in December 2025, capping a nearly 18 percent annual gain. This performance reflected a rotation into cyclical sectors and value stocks, as investors priced in further monetary easing. However, the market's response was tempered by lingering inflation concerns. The 10-year Treasury yield climbed to 4.16 percent by year-end, driven by persistent core PCE inflation (2.8 percent YoY) and the Fed's dovish pivot. The yield curve steepened slightly, with front-end yields falling due to rate cuts and long-end yields rising as inflation remained above target.

Fixed-income markets also signaled a complex outlook. The FOMC's forward guidance emphasized flexibility, with projections for one rate cut in 2026 and another in 2027, ending at 3.125 percent. To maintain ample bank reserves, the Fed announced reserve management purchases of $40 billion in Treasury bills. These actions reinforced a dovish stance, supported by upgraded growth forecasts of 1.7 percent for 2025 and 2.3 percent for 2026.

Looking ahead, the December CPI and FOMC response suggest a policy path where rate cuts in 2026 will be contingent on inflation's trajectory and labor market resilience. If core CPI continues to trend toward 2.5 percent by year-end 2026- as projected by the FOMC-the Fed may feel emboldened to cut rates more aggressively. However, risks remain: a sudden spike in shelter costs or a rebound in energy prices could delay easing. For investors, this uncertainty underscores the need to balance exposure to rate-sensitive sectors (e.g., utilities, real estate) with defensive positions in short-duration bonds.

In conclusion, the December 2025 CPI and Fed policy signal a measured but deliberate shift toward accommodative monetary policy in 2026. While inflation is no longer a runaway train, it remains a drag on growth. The Fed's dual mandate-balancing price stability and employment-will require careful calibration, with markets likely to react sharply to any deviations from the projected path.