USD Recovery and Fed Policy Outlook in 2026: Navigating Inflation and Political Uncertainty

The U.S. dollar's trajectory in 2026 hinges on two critical forces: the Federal Reserve's ability to manage persistent inflation and the political risks threatening the central bank's independence. With inflation data showing modest moderation and Fed Chair Jerome Powell facing unprecedented legal challenges, the interplay between monetary policy and institutional stability is reshaping global capital flows and currency positioning.

Inflation Easing, but Stickiness Lingers

In Q4 2025, U.S. annual inflation, as measured by the Consumer Price Index (CPI), held steady at 2.7%, while core inflation remained at 2.6%. These figures, though below the peak of the post-pandemic surge, still exceed the Fed's 2% target. The December 2025 FOMC meeting reflected this cautious optimism: policymakers trimmed the federal funds rate by 25 basis points to 3.50%-3.75%, signaling a measured easing cycle for 2026. However, the Fed's Summary of Economic Projections underscored lingering risks, with core PCE inflation expected to remain at 2.5% in 2026-a slight downward revision from September but still above the 2% goal.

This "sticky inflation" narrative has constrained the Fed's rate-cutting flexibility. While energy prices have softened and tariffs have recalibrated inflation expectations, the labor market's resilience-unemployment at 4.4%-keeps wage pressures intact. As a result, cross-currency flows remain sensitive to inflation data, with the dollar projected to depreciate by an additional 5% in 2026 as global central banks adopt more accommodative stances.

Powell's Legal Risks: A Threat to Fed Independence

The Trump administration's Department of Justice (DoJ) investigation into Jerome Powell has introduced a new layer of uncertainty. Subpoenas related to the Fed's building renovation and potential criminal charges are widely interpreted as an attempt to politicize monetary policy. Powell has framed the probe as a "pretext to pressure the Fed into cutting rates more aggressively," raising fears of political interference in a central bank long revered for its independence.

This erosion of trust has already impacted market sentiment. The dollar index (DXY00) fell by -0.27% in early 2026 as concerns over Fed independence intensified. Meanwhile, gold prices surged to record highs, with central banks like China's PBOC accelerating gold purchases as a hedge against U.S. policy instability. The euro gained +0.29% against the dollar, reflecting a shift toward safer currencies like the Swiss franc and eurozone assets.

Cross-Currency Flows and the Dollar's Competitiveness

The combination of inflation stickiness and political risk has created a bifurcated landscape for cross-currency flows. Emerging markets are benefiting from the dollar's weakness, with import-dependent economies seeing reduced debt burdens and commodity exporters enjoying stronger local-currency revenues. However, the dollar's traditional safe-haven status is under pressure. Investors are diversifying into alternative currencies and assets, including Bitcoin, as a response to Fed uncertainty.

The Bank of Japan's anticipated 25-basis-point rate hike in 2026 further highlights the dollar's relative unattractiveness, contrasting with the Fed's projected -50-basis-point easing. This divergence is amplifying capital outflows from the U.S., with the yen hitting a 1-year low against the dollar amid concerns over Japan's fiscal policies and geopolitical tensions.

Outlook: A Delicate Balance

The Fed's 2026 policy path will depend on its ability to navigate both economic and political headwinds. While inflation is expected to trend toward 2.1% by 2027, Powell's legal challenges could delay rate cuts if policymakers prioritize institutional credibility over aggressive easing. Goldman Sachs' Jan Hatzius warns that a politically pressured Fed risks undermining long-term inflation expectations, potentially triggering higher bond yields and eroding confidence in U.S. financial institutions.

For the dollar, recovery hinges on two outcomes: a resolution of the Powell investigation that preserves Fed independence and a clear signal that inflation is on a sustainable downward path. Until then, cross-currency flows will remain volatile, with capital favoring assets insulated from U.S. policy uncertainty.

Conclusion

The U.S. dollar's 2026 outlook is a tug-of-war between the Fed's inflation-fighting resolve and the political risks threatening its autonomy. While the central bank's data-dependent approach offers a roadmap for gradual rate cuts, Powell's legal battles are casting a shadow over the dollar's global role. Investors must weigh these dual forces, recognizing that the Fed's institutional integrity-and its ability to act free from political influence-may prove as critical to the dollar's strength as any interest rate decision.