The Fed's Two-Cut Path: Inflation, Labor, and the Political Calculus

The Federal Reserve's path to easing policy in 2026 is now structurally open, but it remains a door that has not yet been pushed through. The necessary condition for further cuts-a sustained, benign inflation environment-has been met. Headline inflation has settled into a quiet lane, with the December Consumer Price Index rising at an annual rate of 2.7%, unchanged from November. More importantly, the core measure, which strips out volatile food and energy, held at 2.6%. This stability, after a year of resilience, creates the policy space. Inflation is no longer the dominant overhang; it is a background condition.

The latest data suggests this benign trend may be gaining a slight tailwind. A nowcast for January points to a 0.22% month-over-month increase in core CPI, a slight deceleration from the prior month's pace. This early signal, if confirmed by the official release, would reinforce the narrative of cooling pressures. For the Fed, this is the setup. With inflation at or below 3% for the entire 2025 calendar year, the central bank has successfully tamed the worst of the price surge that peaked near 9% in 2022. The immediate threat of a wage-price spiral has receded.

Yet, this creates a classic policy dilemma. The door is open, but the Fed's next move depends on what lies beyond it. The central bank's recent decision to cut rates three times in late 2025 was driven by a cooling labor market, not by inflation falling to target. The thesis for further easing in 2026 hinges on the same structural shift: a labor market that continues to deteriorate. Inflation provides the permission slip, but labor weakness provides the imperative. The Fed's independence may be intact, but its timing is increasingly subject to a political calculus that weighs economic growth against persistent price pressures. For now, the benign inflation case has created the opportunity. The decision to act will be made when the labor data confirms the Fed's growing concern.

The Labor Market Imperative: The Primary Catalyst

The Fed's door to easing is now open, but it will only swing wide if the labor market continues to deteriorate. While inflation provides the policy permission slip, labor weakness is the primary catalyst that will force the central bank to act. The data shows this pressure is intensifying. Private sector job growth has slowed meaningfully in late 2025, and the Fed's own projections point to unemployment rising. As economist Mark Zandi notes, job growth will remain insufficient to forestall further increases in unemployment, and the Fed will cut rates as long as that trend persists.

This creates a clear tension between the Fed's internal outlook and the likely external pressure. The central bank's latest dot plot, which aggregates the views of its 19 members, shows a wide dispersion of opinion. The median projection calls for just one cut through the entire year, reflecting a cautious, divided committee. Yet, this median view may not hold. The Fed's own minutes from its last meeting showed the recent cut was a close call, with officials expressing a likelihood of additional reductions but at a tepid pace. The internal division underscores the difficulty of predicting the Fed's next move, but it also highlights the vulnerability of a consensus that could fracture under mounting labor market stress.

Political pressure is expected to grow, further increasing the risk of policy accommodation. Ahead of the midterm elections, the administration is likely to intensify its push for lower rates. This dynamic is already visible in the central bank's composition, with three of its seven governors appointed by President Trump. The threat of a new administration appointing more loyalists, including a potential replacement for Chair Jerome Powell in May, adds a layer of political calculus to the Fed's independence. As one observer put it, the threat of criminal charges is a consequence of the Federal Reserve setting interest rates based on our best assessment of what will serve the public, rather than following the preferences of the President. This unprecedented legal threat against Chair Powell is a stark signal of the political pressure the Fed now faces.

The bottom line is that the benign inflation environment has created the opportunity for easing, but the labor market will provide the imperative. The Fed's cautious dot plot median of one cut may be a starting point, but it is not a guarantee. If unemployment continues to climb, the confluence of weak hiring, internal division, and escalating political pressure could compel a more aggressive pivot than currently priced. The primary catalyst for a two-cut path in 2026 is not inflation, but the deteriorating health of the job market.

The Path to Two Cuts: Timeline and Catalysts

The immediate catalyst is the Federal Open Market Committee's meeting on January 27-28. Market pricing gives a low probability of a cut at that gathering, with a 13.8% chance according to CME futures. The latest inflation data, with the CPI unchanged at an annual rate of 2.7% and core CPI at 2.6%, provides no clear reason for the Fed to move. As analysts noted, this report "doesn't give the Fed what it needs to cut interest rates" later this month. The central bank is expected to hold steady, maintaining rates in the 3.5% to 3.75% range.

The path to a two-cut year hinges on a break in this pattern. The primary signal for a change in the Fed's patience is a clear and sustained decline in core inflation, specifically a break below the current 2.5%-2.7% range. While the latest data shows stability, the risk is that inflation remains sticky, preventing the Fed from acting even as labor weakens. The trajectory of the unemployment rate is the other critical variable. The Fed's own projections point to rising unemployment, and economists like Mark Zandi argue that as long as unemployment is on the rise, the Fed will cut rates. His forecast for a more aggressive three-cut path before midyear is predicated on this confluence of a flagging job market and cooling inflation.

For now, the market and the Fed's internal dot plot are pricing a much slower pace. The CME FedWatch gauge points to two cuts, with the first not coming until at least April and the second likely in the second half of the year. The Fed's own grid shows a median expectation for just one cut through the entire year. This cautious outlook reflects the committee's division and its focus on ensuring inflation is on a durable path to 2%. Yet, this median view is vulnerable. It assumes the labor market deteriorates at a steady, predictable pace. If job growth slows further and unemployment climbs faster than expected, the combination of weak hiring, internal division, and intensifying political pressure could compel a more rapid pivot than currently priced.

The bottom line is that the Fed's path is not predetermined. The January meeting is a checkpoint, not a decision. The catalysts for a two-cut year are clear: a confirmed break in the core CPI range and a visible uptick in the unemployment rate. Until those signals emerge, the Fed's patience will be tested. The market's low probability of a January cut suggests the central bank is waiting for more evidence. For investors, the setup is one of cautious optimism for easing, but with the timing and pace hanging on the next set of labor and inflation reports.