Paulson's 2% Target: A Fragile Convergence of Disinflationary Forces

Federal Reserve Bank of Philadelphia President Anna Paulson's forecast for inflation to reach the Fed's 2% target by year-end hinges on a delicate convergence of forces. Her outlook is one of cautious optimism, specifically expecting three-month inflation to come down to 2% by the end of 2026. Yet she tempers this with the view that 12-month inflation may still be a little elevated at that point. This distinction is critical: the market's focus is on the shorter-term, more volatile measure, but the Fed's ultimate goal is the longer-term run rate. Paulson's baseline outlook requires this precise alignment: inflation must continue to moderate, the job market must stabilize, and GDP growth must hold around 2%. As she stated, her baseline outlook is pretty benign with these conditions met.

This forecast unfolds against a backdrop of recent monetary easing. The Fed has already delivered three consecutive reductions, cutting rates by a quarter point in December to a target range of 3.5% to 3.75%. The central bank's own projections, however, signal a restrained path forward. The median of the Fed's "dot plot" shows only one rate cut in 2026. This reflects a committee divided on the pace of further easing, with Paulson herself noting that the current stance of monetary policy is a little restrictive. In her view, this existing restrictiveness, combined with past cuts, is what will ultimately bring inflation all the way to 2%.

The path, therefore, is narrow. Paulson's scenario depends on disinflationary pressures gaining enough traction to offset persistent headwinds. One such headwind is the lingering impact of tariffs, which Fed officials have noted have already meaningfully increased prices for imported goods. Another is the potential for further price adjustments by producers, even as Paulson suggests the consumer market has already seen a lot of price adjustments. The January inflation data will be a key test, as it arrives at a time when firms are naturally inclined to reset prices. For Paulson's forecast to hold, these forces must now work in concert. Any stumble in the job market stabilization or a sharper-than-expected inflation peak could quickly derail the fragile convergence she is banking on.

The Inflation Mechanism: Disinflation in Goods vs. Persistent Headwinds

The path to Paulson's 2% target is being mapped by a clear but fragile divergence in price pressures. The headline numbers show a pattern of moderation, yet the underlying mechanics reveal a story of uneven progress. The latest data point to a disinflationary trend that is underway but far from complete. The consumer price index rose 2.7% in December from 12 months earlier, a figure that held steady from the prior month. This follows a core PCE inflation reading of 2.8% in September 2025. The Cleveland Fed's nowcast for the first quarter of 2026 provides a forward-looking signal, projecting three-month CPI inflation at 2.26%. This indicates the disinflationary trend is gaining traction, but the target remains out of reach.

The critical insight is that this progress is narrowly confined. Price pressures are largely a story of goods, while services inflation is easing. As Paulson noted, price pressures will largely be confined to goods, a dynamic driven by the lingering impact of tariffs. These levies have acted as a direct tax on imports, pushing up goods prices. Economists estimate they have pushed up inflation a little over half a percentage point. The market's focus is on the January data, which will be especially useful for gauging whether producers have completed their price adjustments. Paulson herself stated that we've already seen a lot of the price adjustments, but the beginning of the year is a natural reset period for firms.

This creates a counterweight in the housing sector. While services inflation eases, data on housing inflation have been "unambiguously good". This suggests that the disinflationary forces in services and housing are helping to offset the persistent upward pressure from goods. The bottom line is a fragile equilibrium. The disinflationary trend is real, as shown by the nowcast, but it is being held in check by structural headwinds. The January inflation report will be the next key test, revealing whether the tariff-driven goods inflation has peaked or if further price adjustments by producers could slow the overall decline.

Labor Market and Growth: The Stabilization Test

For Paulson's benign baseline to hold, two pillars must remain intact: a labor market that is softening but not collapsing, and economic growth that finds a steady, if modest, footing. The first is already under scrutiny. Payroll growth has fallen sharply, with a staggering nearly 90% of net private job creation in a single sector through November 2025. This extreme concentration points to a labor market that is clearly bending, as Paulson herself noted, but not breaking. The risks have risen, which was a key factor in her support for the 75 basis points of cuts that the FOMC did last year. The challenge now is to see if this softening stabilizes at a sustainable level, rather than accelerating into a downturn.

The second pillar is growth. Paulson's forecast assumes the economy will grow around 2% this year. This would require a notable shift from recent tepid hiring to more robust activity. The disconnect between weak labor data and resilient GDP numbers is a central puzzle. As Paulson observed, the job market is a better barometer of economic momentum than growth data. For the 2% growth target to be viable, it must be supported by a labor market that is stabilizing, not one that is still shedding jobs. The current setup suggests a fragile equilibrium where growth is holding up despite a weakening labor market, but this is not a sustainable long-term path.

The bottom line is that Paulson's forecast is a test of stabilization, not strength. The labor market must find a new, lower equilibrium that prevents a sharp rise in unemployment, while growth must accelerate from its recent pace to hit the 2% mark. Any stumble in either condition would undermine the entire convergence she is banking on. The January inflation data will be a key early signal, but the true test will come from the labor reports and GDP prints over the coming quarters.

Catalysts, Risks, and What to Watch

The path to Paulson's 2% target is now a series of high-stakes tests. The immediate catalyst is the January inflation data, which will be a critical signal for whether the disinflationary trend is gaining momentum or stalling. As Paulson noted, the beginning of the year is a natural reset period for firms, making this report especially useful for gauging if producers have completed their price adjustments. She has stated that we've already seen a lot of the price adjustments, but the data will confirm if that process is truly winding down or if further increases are still on the table.

The key risks to this fragile convergence are structural and persistent. First, inflation for staples and necessities remains elevated, a direct drag on the consumer basket. As economist Mark Zandi observed, inflation for staples, necessities, remains elevated, a condition that could keep headline inflation above target for longer. Second, there is the ever-present risk of services inflation re-accelerating. While housing data has been positive, the broader services sector is the most difficult to tame. Any resurgence in wage pressures or shelter costs could quickly undermine the progress seen in goods and three-month measures.

Finally, the uncertainty around the Federal Reserve's own path creates a major overhang. The central bank's updated "dot plot" shows a wide dispersion of views, with no clear consensus on the path for rates in 2026. The median projection calls for just one more cut, but the range of individual forecasts is broad. This division, highlighted by the clouded outlook for future rate cuts following the December meeting, means the policy response to any data miss is unpredictable. For Paulson's forecast to hold, the Fed must maintain its current stance of being a little restrictive while the economy stabilizes. If inflation data disappoints, the lack of a unified committee view could lead to either too little or too much easing, derailing the delicate balance.

The bottom line is that the coming months are about confirmation. The January report will test the completion of price adjustments. The labor market and growth data will test the stability of the soft-landing. And the Fed's reaction will test the unity of its policy response. Any stumble in these areas could quickly invalidate the narrow path to 2%.