Core Inflation at 2.6%: The Fed's Structural Pause and 2026 Easing Path

The Federal Reserve now faces a clear, if frustrating, plateau. Core inflation, the measure the central bank watches most closely, held at 2.6% annually in December, unchanged from November. This marks the 55th consecutive month that core inflation has remained above the Fed's 2% target, a structural reality that provides little justification for an immediate policy pivot. The data for the month itself showed a sharp acceleration, with the monthly pace jumping to 0.3% from November's 0.1%. The driver was a 0.7% surge in food prices, a persistent pain point for households, alongside persistent housing costs.

This new normal is the backdrop for the Fed's likely stance through early 2026. Officials, including New York Fed President John Williams, have signaled they are "well positioned" and that the current policy range of 3.5% to 3.75% is "closer to neutral." With inflation still running hot and the labor market showing only modest signs of softening, the central bank is expected to maintain its current policy stance. The path to lower rates is now firmly set for the latter half of the year, but the trigger will be a sustained and credible decline in underlying price pressures, not a single monthly reading.

The bottom line is one of enforced patience. The Fed's mandate is to achieve stable prices and a healthy labor market, but it cannot act on political pressure. As Williams noted, jeopardizing the central bank's independence risks "unfortunate outcomes" marked by higher inflation. For now, the 2.6% core CPI rate means the Fed's work is not done.

The Labor Market Context: A Tightrope Walk

The Federal Reserve's stated rationale for a pause is now clear: the labor market is showing tentative signs of stabilizing, which reduces the immediate need for policy easing. After a year of weak hiring, the December jobs report revealed a critical balance. The unemployment rate ticked down, but hiring slowed to levels not seen since the pandemic. This combination creates the very conundrum the central bank must navigate. It signals enough strength to avoid a sharp downturn, but not enough momentum to justify a rate cut. As Goldman Sachs noted, the data convinced investors with near certainty that the Fed would hold steady, with futures now pricing no cut until June.

This delicate balance is set against a backdrop of intense political pressure. The administration has escalated its campaign against the Fed, opening a criminal investigation into Chair Jerome Powell this weekend. The probe, centered on a renovation project, is widely seen as an attempt to use legal threats to push for lower borrowing costs. Powell's rare rebuke of the administration underscores the threat to the central bank's independence. As New York Fed President John Williams warned, jeopardizing that independence risks "unfortunate outcomes" marked by higher inflation. The Fed's mandate is to manage both price stability and maximum employment, but it cannot act on political pressure.

The bottom line is one of enforced patience. The Fed's work is not done, as inflation remains stubbornly above target. Yet, with the labor market in this state of fragile equilibrium and political threats mounting, the path forward is narrow. Officials are likely to hold course, waiting for clearer signals from inflation data before easing again. The market's dovish expectation for a June cut reflects this wait-and-see stance. For now, the Fed is walking a tightrope, balancing economic data against political headwinds, with its independence itself now a key variable in the equation.

The 2026 Rate Path: From Pause to Gradual Easing

The consensus view for 2026 is one of deliberate, data-driven easing. The Federal Reserve is expected to bring its benchmark interest rate range down from the current 3.50% to 3.75% to closer to 3% over the course of the year. This path reflects the central bank's stated goal of achieving a neutral policy rate, where its influence on the economy is neither stimulative nor restrictive. The journey will likely begin with a pause early in the year, as officials assess the incoming data and a new chair takes the helm following Chair Jerome Powell's term expiration in May.

Morgan Stanley's specific forecast aligns with this gradual approach. The firm sees the first rate cut occurring in June 2026, followed by a second reduction in September. This two-step plan is explicitly contingent on sustained progress in inflation returning toward the Fed's 2% target. The bank's outlook underscores the central bank's commitment to a process, not a prediction. Any move will be guided by the evolution of economic data, particularly on inflation and the labor market, as officials navigate their dual mandate.

The trigger for that first cut, therefore, is a clear, persistent downward trend in core inflation. The current 2.6% level provides no immediate justification for easing. The Fed's patience is not a sign of inaction but a recognition that monetary policy must wait for credible evidence that underlying price pressures are cooling. This data-dependent timing creates a forward-looking setup for financial markets. Investors should expect a period of stability in short-term rates through the first half of the year, with the focus shifting to inflation prints and employment reports as the key signals for the June decision. The bottom line is a path of gradual easing, where the pace is dictated by the economy's performance, not a predetermined calendar.

Investment Implications and Key Catalysts

For investors, the macro narrative translates into a clear set of watchpoints. The immediate catalyst is the Federal Reserve's January 27-28 meeting, where a pause is expected. The market has already priced this in, with futures indicating no cut until June. The focus will then shift to the data that will guide the first move: the stability of core inflation and the health of the labor market.

The key data to monitor is the stability of core inflation, particularly its services and shelter components. The December report showed the monthly pace accelerating to 0.3%, driven by a sharp jump in food prices. While the annual core rate held at 2.6%, the underlying components remain volatile. Investors should watch for signs of re-acceleration in services inflation, which has been a persistent source of stickiness, or sustained deceleration that would signal the Fed's target is within reach. The labor market data, which showed hiring slowing to levels not seen since the pandemic, will also be scrutinized for any further softening that could eventually tip the balance toward easing.

A layer of policy uncertainty is introduced by the potential for a new Fed Chair following Chair Jerome Powell's term expiration in May 2026. This transition, coupled with the administration's criminal investigation into Powell, raises the stakes for the second half of the year. The incoming leadership could bring a different policy temperament, adding a variable to the data-dependent path. For now, the consensus is for a gradual easing of the benchmark rate range from 3.50% to 3.75% toward 3% over 2026. But the pace and timing of that easing will hinge on the inflation data and the political backdrop. The bottom line is one of enforced patience: the first major policy shift is likely not until June, and the path beyond that will be dictated by economic performance and the evolving leadership at the central bank.