The Powell era concludes as the specter of inflation forces Wall Street to reassess the Federal Reserve's path to interest rate cuts.
Incoming Fed Chair Kevin Warsh is expected to be confirmed by the Senate on Monday and officially take over the helm from Jerome Powell on May 15. However, he will not be greeted with an easing start: ongoing Middle East conflicts continue to push up energy prices, and the U.S. labor market remains resilient—leaving the Fed with "no room to cut."
Goldman Sachs' latest report has postponed its previously forecasted two rate cuts—previously expected in September and December 2026—to December 2026 and March 2027, respectively. The core reasons are: rising energy costs and sustained demand related to artificial intelligence are jointly driving the year-over-year growth rate of the U.S. core Personal Consumption Expenditures (PCE) index closer to 3%. Concurrently, the report has lowered its probability forecast for an economic recession to 25%.
For investors, a "higher for longer" interest rate environment is returning, with markets fully pricing in the policy rate remaining within the 3.50%–3.75% range by year-end. Goldman Sachs warns that if the economy remains robust, the Fed could pause rate cuts indefinitely, and investors should prepare defensively for a scenario of "no room to cut" in the second half of 2026.
Multiple Factors Drive Up Core PCE, Conditions for Rate Cuts This Year Not Yet Ripe
Against the backdrop of a deteriorating inflation path, the threshold for rate cuts has been substantially raised.
The pass-through effects of energy prices, additional shocks related to the Middle East war, and the impact of AI demand on consumer prices (though this factor may be overestimated) are expected to keep the full-year core PCE year-over-year growth closer to 3% than 2%. Even as the base effects from last year's tariff measures gradually exit the year-over-year calculation, the impact of energy price transmission is projected to persist through year-end.
Notably, before the outbreak of the war, many Fed officials had already indicated they would need to see official inflation data move closer to the 2% target before considering restarting rate cuts. An upward shift in the inflation path will further strengthen this camp, thereby substantively raising the bar for rate cuts.
Goldman Sachs expects that by the second half of 2026, as the effects of tariffs and energy price transmission gradually fade, the month-over-month core PCE will decline significantly, with the annualized rate falling below 2%. Conditions for rate cuts will eventually be met, but more time is needed to wait.
Mixed Employment Report, Fed Still Needs to Wait and See
The April employment report released mixed signals, failing to provide clear direction for rate cuts.
On one hand, strong non-farm payroll data revised up the trend estimate for monthly job growth to approximately 51,000, returning close to the estimated breakeven rate—indicating that job expansion remains resilient and shows no signs of weakness requiring policy easing. On the other hand, the unrounded unemployment rate rose by 0.08 percentage points, and the U6 broad unemployment rate increased by 0.2 percentage points—loosening in the labor market is still progressing slowly, with increased slack, preserving potential room for future rate cuts.
Due to surging oil prices leading economic activity below potential levels and the potential for greater resistance from AI, hiring is expected to be suppressed, with the unemployment rate potentially rising to 4.6% by year-end. However, the report holds reservations about this judgment: recent non-farm data has consistently exceeded expectations, and business surveys and early physical data following the war and oil price shocks have remained resilient.
If the U.S. labor market does not soften sufficiently this year, an alternative forecast scenario is: the Fed will implement the final two rate cuts in 2027, by which time core inflation is expected to have fallen back to the 2% target level.
Terminal Rate Unchanged, but Risk of "Permanent Pause" Rises
Goldman Sachs' latest forecast indicates that the terminal rate for this easing cycle will settle in the 3%–3.25% range. This judgment is primarily based on: Fed officials' estimates of the neutral rate have remained stable recently, and most still expect at least a few more rate cuts.
However, a non-negligible risk scenario is emerging: if the economy remains robust throughout the year at the current federal funds rate level, some officials may revise up their neutral rate expectations, concluding that no further rate cuts are necessary.
The updated probability distribution for Fed scenarios is as follows:
Rate Hike Scenario (small hike): Probability 10%
Permanent Hold (federal funds rate unchanged indefinitely): Probability 25%
Baseline Scenario (one rate cut in December 2026 and one in March 2027): Probability 40%
Recession Scenario (recession within the next 12 months): Probability 25%, down 5 percentage points from before
Goldman Sachs' probability-weighted interest rate forecast path remains significantly more dovish than current market pricing. The core reason is that Goldman Sachs has almost ruled out any possibility of rate hikes—even as it has considered scenarios of delayed rate cuts or a "permanent pause."
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