Decoding the Fed's December Cut: What Was Priced In and What's Next

The Federal Reserve's December move was a textbook case of the market buying the rumor and the Fed delivering the print. The central bank cut its benchmark rate by 25 basis points to a range of 3.5%–3.75%, the third reduction of the year and a decision that had been widely priced in. For investors, the action itself was the expected outcome. The real story, however, was the deep internal division that accompanied it.

The key surprise was the dissent. The 9-3 vote marked the first time the FOMC split three ways since September 2019, a stark signal that the committee's unity on the path forward has frayed. The split wasn't just about the size of the cut; it was a fundamental disagreement over policy priorities. On one side, Governor Stephen Miran pushed for a steeper half-point reduction, aligning with dovish concerns about a softening labor market. On the other, regional presidents Jeffrey Schmid and Austan Goolsbee voted to hold the line, reflecting hawkish worries that inflation could become entrenched. This was the third consecutive dissent from Miran, underscoring a persistent rift.

Viewed through the lens of expectation arbitrage, the market had priced in the cut but not the division. The consensus was for a "hawkish cut," and the Fed delivered. The expectation gap now lies in the forward view. The committee's projections, unchanged from September, signal only one more 25bps cut in 2026. Yet the internal debate suggests that the path to that single cut-and beyond-will be far more contentious than the current dot plot implies. The real risk isn't the next move; it's the volatility that comes from a committee that can no longer agree on the direction.

The Expectation Gap: FOMC Projections vs. Market Pricing

The market's calm pricing of a steady hand contrasts sharply with the Fed's own projections, revealing a clear expectation gap. Official forecasts show a more hawkish constraint than traders are currently pricing in.

The FOMC's median projections, released in December, point to a labor market that will continue to soften. The committee sees the unemployment rate averaging 4.4% in Q4 2026, a slight dip from the prior year. More telling is the inflation outlook. While the median forecast for core PCE inflation of 2.5% for 2026 is a touch lower than the September projection, it remains notably above the Fed's 2% target. This is the core tension: the Fed is acknowledging persistent price pressures even as it cuts rates.

Market pricing, however, is looking past this hawkish constraint. According to FedWatch, traders are assigning a ~95% chance the Fed holds rates steady at the January meeting. This implies a market view that inflation is cooling fast enough to allow a pause, and that the labor market weakness is the dominant policy driver. The expectation gap is that the market is pricing in a slow, deliberate path of cuts, while the FOMC's projections suggest a more constrained environment where inflation remains a persistent overhang.

This disconnect sets the stage for volatility. If inflation data in the coming months shows the 2.5% projection is too optimistic, the market's low-probability bet on a hold could quickly shift. The Fed's own numbers suggest the path to its 2% target is longer and more uncertain than the market consensus assumes. For now, the market is betting the Fed will wait, but the projections hint that it may have less room to wait than traders think.

Market Reaction and the Whisper Number

The market's reaction to the December cut was a classic "buy the rumor, sell the news" dynamic. The whisper number was a 25bps reduction, and the Fed delivered it exactly. This move was fully priced in, which is why Treasury yields saw no significant directional shift. The action itself met the consensus, so there was no new information to drive a sustained rally or sell-off.

The real surprise-and the source of the day's volatility-was the 9-3 dissent vote. That split was not fully priced in. It added a layer of uncertainty that the simple cut did not. The three "no" votes, including Governor Stephen Miran's call for a steeper half-point reduction, signaled a more hawkish tilt than the consensus move alone suggested. This internal division is the expectation gap that now matters. It tells traders that the path to the Fed's projected single cut in 2026 will be fraught with debate, not a smooth glide path.

With the cut delivered and the dissent noted, the market's focus has now snapped to the next data point: the January CPI report. This will be the first major test of whether core inflation is truly easing toward the 2% target. The market is betting that it is, but the Fed's own projections show it is not. The January data will determine if the market's low-probability bet on a hold at the next meeting is correct-or if the Fed's hawkish concerns are already being validated.

Catalysts and Risks: What Could Close the Expectation Gap

The current equilibrium between the Fed's hawkish projections and the market's dovish bets is fragile. It rests on a single, critical assumption: that inflation is easing toward the 2% target. The January CPI report will be the first major test of that assumption, and it will be scrutinized for any sign that core pressures are holding firm.

The market is pricing in a smooth path of cuts, but the Fed's own numbers show core PCE inflation stuck at 2.6% over the past 12 months, well above target. If the January CPI shows core inflation cooling to the Fed's 2.5% projection for 2026, it will validate the market's low-probability bet on a hold in January. But if the data reveals sticky pressures, the expectation gap will snap shut. The Fed's own minutes noted a division over risks between higher inflation and unemployment, with some officials warning that inflation could become entrenched. A hot CPI report would give those hawkish concerns immediate credibility and likely force a reassessment of the Fed's projected single cut in 2026.

Labor market data will provide the other half of the equation. The dovish dissents in December were driven by concerns over a softening labor market. The January jobs report will be critical in assessing that risk. If unemployment starts to rise significantly, it will reinforce the case for more cuts, supporting the market's current view. But if the labor market proves resilient, it could shift the balance of power within the Fed, making the hawkish faction's warnings about inflation becoming entrenched more influential.

Finally, a potential operational shift could signal a change in focus independent of rate moves. The Fed's minutes noted that market participants' expectations for the policy rate path were little changed, but they also highlighted that inflation compensation moved lower over the period. This suggests the market is already pricing in a more dovish stance. The Fed's potential start of Reserve Management Purchases (RMPs) in January to manage reserves could be a subtle signal that the central bank is preparing for a longer period of low rates, even if it doesn't cut again. This would be a technical adjustment that doesn't change the rate path but could affect liquidity conditions and market psychology.

The bottom line is that the expectation gap will only close when hard data forces a reckoning. The January CPI is the primary catalyst, but the labor report and any operational moves will determine the direction of that reckoning. For now, the market is betting the Fed will wait. The Fed's own projections suggest it may have less room to wait than traders think.

Practical Takeaways: Navigating the Expectation Arbitrage

The setup for investors is clear: the market has priced in a slow, steady path of cuts, but the Fed's own projections show a more constrained environment. The expectation gap is now defined by that internal division. The market is betting the Fed will wait, but the FOMC's projections suggest it may have less room to wait than traders think. This creates a specific arbitrage opportunity: position for the volatility that will come when data forces a reckoning.

First, watch for a potential 'guidance reset' in the coming weeks. The market's low-probability bet on a hold at the January meeting hinges on inflation cooling toward the Fed's 2.5% projection for 2026. The latest CPI data shows core inflation at 2.6% over the past 12 months, just above that target. If the January CPI report shows core inflation accelerating above that 2.5% mark, it would signal the Fed's hawkish concerns are being validated. This could pressure the committee to hold rates longer than the current market consensus assumes, leading to a sharp repricing of the policy path. The January jobs report will provide the other half of the equation, but the CPI is the primary catalyst for a guidance reset.

Second, the primary risk is that the Fed's hawkish dissents become more influential. The December meeting's 9-3 split was a warning shot. If future inflation data remains sticky, the faction concerned about inflation becoming entrenched could gain the upper hand. This would likely lead to a 'sell the news' dynamic. The market is already looking past the current 3.75% rate to a two-cut path in 2026. If the Fed disappoints by delivering only one cut, or delays the second, the stock market's rally on the "buy the rumor" trade could reverse sharply. The expectation gap will close not with a bang, but with a series of data points that force the Fed to either accelerate or delay its cuts, moving the actual path further from the market's current two-cut assumption.

The bottom line is to prepare for a volatile transition. The Fed's internal debate means the path to its projected single cut in 2026 will be fraught with uncertainty. Investors should monitor the January CPI and jobs reports as the key signals that will determine whether the market's dovish bet holds or if the Fed's hawkish constraint reasserts itself.