In 2025, the Federal Reserve faced a conflict between its two congressionally mandated goals—full employment and price stability—a situation not seen since the stagflation of the 1970s. This contradiction led to rare, deep divisions within the Fed, as evidenced by the stark disagreement over interest rate policy between opposing factions. This dynamic is expected to persist into 2026.
Matthew Luzzetti, Chief US Economist at Deutsche Bank, noted that Fed Chair Jerome Powell had managed to build consensus within a divided Fed to push through three rate cuts this year. However, if high inflation persists alongside a softening labor market, a new Fed Chair could find it significantly more challenging to forge agreement. Luzzetti stated, "While the most likely path remains further rate cuts in the future, we also see a risk scenario where the next Chair could ultimately face a committee considering rate hikes." Huntington Bank Chief Economist Ian Wyatt commented, "The new Chair will face the daunting task of mediating disagreements and building consensus in this environment, especially if their views deviate substantially from the median stance of most Governors."
President Trump's growing influence, marked by a series of dramatic economic policy shifts in 2025—from roller-coaster tariff rates to border closures aimed at curbing immigration—kept the Fed on hold for most of the year as officials attempted to gauge the policies' impact on the economy, inflation, and employment. The Fed's inaction frustrated Trump, who repeatedly pressured the central bank to cut rates and seized on technicalities in an attempt to remove Powell. The threat of firing Powell over policy differences raised concerns about jeopardizing the Fed's independence and rattled markets. Although the President ultimately did not dismiss Powell, he did remove Fed Governor Lisa Cook from her position, citing alleged mortgage fraud—a case still working its way through the courts, with the Supreme Court scheduled to hear it in early 2026. Simultaneously, Fed Governor Adriana Kugler departed in the summer, prompting the President to appoint White House Council of Economic Advisers Chair Stephen Milan to fill the remaining five months of her term. Milan did not resign his White House post, taking only a temporary leave. This move alarmed many Fed watchers, who feared it could undermine the Fed's independence—a concern Milan himself had warned about before joining the government.
Initially, many Fed officials believed tariffs would cause only a one-time price increase, not translating into persistent inflation. However, when the "Emancipation Day" tariffs—the highest and most extensive in a century—took effect on April 2nd, more officials began to worry they could lead to sustained inflationary pressures. By July, signs of cooling emerged in the labor market. The Fed held rates steady at its policy meeting—consistent with its stance all year—but faced dissent from Governors Christopher Waller and Michelle Bowman, who preferred a preemptive rate cut to cushion the labor market. This was the clearest evidence yet of a deep split within the Fed: differing assessments of inflation's persistence and disagreement on the appropriate level of vigilance in response to labor market weakness. As summer drew to a close, employment data showed more significant signs of weakness than expected, prompting Powell to pave the way for a September rate cut. This initiated the first of three cuts in the autumn, mirroring the rate-cutting path of 2024. The government shutdown also set a record for the longest in history, leaving the Fed struggling to make key rate decisions without official data. Officials were forced to rely on private-sector data—which was relatively plentiful for the labor market but severely lacking for inflation and price indicators.
By December, the Fed's internal divisions were out in the open. Although the Fed ultimately delivered its third cut of the year this month, two voting members—Chicago Fed President Austan Goolsbee and Kansas City Fed President Jeff Schmid—argued for holding rates steady due to inflation concerns. On the other side, Stephen Milan dissented, advocating for a larger 50-basis-point cut. Six other non-voting members also indicated a preference for no cut this month. Despite widespread concern that tariffs would boost inflation, their actual impact this year was weaker than expected. Some officials, including Chair Powell and Governor Waller, projected that tariff-induced inflation would peak in the first quarter of 2026 and then gradually recede. However, other officials who will be voters next year, such as Cleveland Fed President Beth Hammack and Dallas Fed President Lorie Logan, worried that inflation could prove sticky and remain elevated for longer.
Following three so-called "insurance cuts," and with inflation still high, the rate-setting committee has signaled it needs time to fully assess the economic situation before considering further easing. After multiple delays, more recent data has begun to trickle in, but the overall economic picture remains murky as the government shutdown distorted statistical results. The Fed faces greater challenges in forecasting and formulating appropriate policy without a clearer view of the economy. The latest November inflation report showed a significant slowdown in price increases, partly due to falling rents being incorporated into the calculation. However, many are skeptical of the report's accuracy due to data gaps caused by the shutdown. New York Fed President John Williams suggested that the latest Consumer Price Index (CPI) reading might understate inflation by about 0.1 percentage points, while Hammack believed the underestimation could be 0.2 to 0.3 percentage points. Meanwhile, the unemployment rate has crept up to 4.6%.
Looking ahead to 2026, policymakers anticipate only one more rate cut next year. Although the labor market is cooling, they do not view this weakness as constituting an emergency. At the same time, inflation remains above the 2% target, and officials expect economic growth to accelerate next year, fueled by both fiscal tailwinds from the tax reform bill and a post-shutdown rebound. Jeffrey Roach, Chief Economist at LPL Financial, expects volatile inflation data in the coming months but believes inflation will moderate next year, opening policy space for multiple subsequent cuts. He stated, "As larger-than-expected tax refunds boost demand early in 2026, we might see more signs of heating inflation, but we anticipate cooling in the second half of the year." Former Kansas City Fed President Esther George expects unemployment to stabilize next year but remain relatively high; simultaneously, she projects inflation will stay elevated due to massive fiscal deficit spending, ongoing concerns about Fed independence, and loose financial conditions. George said, "Due to the disruption in official data releases, the FOMC is likely to proceed cautiously but maintain a bias toward cutting rates in 2026, reasoning that these cuts would move the policy rate toward a neutral level."
Next year will also see the first change in Fed leadership in eight years. The President is widely expected to nominate a candidate supportive of rate cuts. Even so, if inflation remains stubbornly high, a new Chair could face challenges building consensus for easing. Cleveland Fed's Beth Hammack (a voting member next year) has already publicly voiced support for holding rates steady until next spring. Wilmer Stith, Bond Portfolio Manager at Wilmington Trust, expects divisions to persist into next year, with more dissents possible if a new Chair tries to force through rate cuts against the committee's opposition. He also anticipates the Trump administration will continue its campaign to push rates lower. However, with Powell's term lasting until May, Stith does not expect multiple cuts in the first half of the year. He foresees only one cut between January and May. Stith said, "I think once the new Chair is in place, we will see multiple cuts throughout the year. It will be a period of closer alignment [between the Fed] and the government... something we haven't seen in a long time. So, I believe rate cuts are coming."
The US dollar's trajectory in 2026 is likely to be characterized by "high volatility, no clear trend," with its core trading range determined by the tug-of-war between "US inflation-employment data combinations" and "shifts in the Fed's internal voting blocs and the new Chair's leadership." Political intervention represents a significant downside risk that cannot be ignored. In the short term, during Powell's remaining tenure and amid unclear data, the dollar may remain relatively resilient due to Fed caution. However, as a new Chair takes over, data clarifies, and a rate-cutting cycle gains clearer momentum, the probability of dollar weakness in the second half of the year is increasing. In early Asian trading on Friday (December 26th), the dollar index was fluctuating narrowly near a two-and-a-half-month low.
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