There has been an increasing gap between the Federal Reserve and financial markets regarding the direction of U.S. benchmark rates in 2026. While the Fed signals caution with further cuts, the markets are betting on two to three reductions this year.
The core of this distance is an uncomfortable paradox: President Donald Trump's push for lower rates may be undermined by the very inflation that threatens his political survival.
The market is betting on interest rate cuts by mid-year
According to the forecast market Polymarket, the probability of an interest rate cut at the January meeting of the Federal Open Market Committee (FOMC) is only 12%. Most expect the rate to remain unchanged this month.
But the picture changes dramatically over the longer term. The probability of a rate cut by April rises to 81%, and by June it reaches 94%. For the entire year, the scenario of two cuts has the highest probability at 24%, followed by three cuts (20%) and four cuts (17%). Overall, there is over an 87% probability of two or more cuts.
The CME FedWatch tool, which shows expectations in interest-related futures, provides a similar picture. The probability of keeping interest rates unchanged in January is 82.8%, about the same as Polymarket. The probability of at least one cut by June is 82.8%, while the probability of two to three cuts by the end of the year is 94.8%.
The market consensus is clear: keep rates steady in January, begin cutting in the first half of the year, and deliver two to three cuts by December.
Fed hawks signal no rush
Internally at the Fed, however, a different narrative is developing. On January 4, Philadelphia Fed President Anna Paulson indicated that further rate cuts may not be relevant until "later in the year."
Paulson, who has a vote in the FOMC in 2026, stated that "some minor adjustments to the interest rate will likely be appropriate later in the year"—but only if inflation eases, the labor market stabilizes, and growth hovers around 2%. She described the current monetary policy as "still somewhat tight," and suggested that it is still contributing to reducing inflationary pressure.
Her statements stand in stark contrast to the market's expectations of a rate cut in the first half of the year. The message from the Fed's hawkish camp is clear: do not expect measures anytime soon.
December FOMC: A divided committee
The FOMC meeting in December revealed how divided the Fed is now.
The committee cut rates by 25 basis points, setting the target range at 3.5%–3.75%. But the vote ended 9–3, wider than the previous 10–2. Two members, Schmid and Goolsbee, wanted to keep the rate unchanged. At the other end, Miran—widely perceived to align with the Trump administration—pushed for a 50 basis point cut.
The dot plot told an even clearer story. Although the median forecast was a single cut in 2026, the distribution was wide. Seven officials did not envision any cuts, while eight expected two or more cuts. The most dovish forecast indicated that rates could fall all the way down to 2.125%.
The Fed's official guidance suggests one cut. The markets are pricing in two. Why this persistent gap?
Why the markets bet on the doves: The Trump Factor
The main reason the markets do not believe in the Fed's hawkish signals is President Donald Trump.
Since he returned to office, Trump has regularly pressured the Fed for lower rates. The FOMC vote in December—where a Trump ally advocated for a more aggressive tightening—clearly shows this picture.
Even more importantly: Fed Chair Jerome Powell's term expires in 2026. The president has the power to appoint his successor. Market participants broadly expect Trump to place a candidate who is more open to his desire for a looser monetary policy.
Structural factors reinforce this view. Historically, the Fed has turned to rate cuts when the labor market weakens. FOMC divisions are deepening. Additionally, there are fears that trade policy could hinder growth further, thereby creating greater pressure for easing.
The market's bet is simple: Trump's pressure, combined with a potential economic downturn, will ultimately force the Fed to act.
The midterm paradox: Inflation is Trump's Achilles' heel
Here lies the central irony. For Trump to effectively pressure the Fed, he needs political capital. But this capital is diminishing—due to inflation.
Recent polls show that Trump's approval on economic policy has fallen to 36%. In a PBS/NPR/Marist survey, 57% of participants said they disapproved of his economic management. A CBS/YouGov poll found that 50% of Americans say their economic situation has worsened under Trump's policies.
The reason is high prices. According to Bureau of Labor Statistics data, ground beef prices have increased by 48% since July 2020, while a McDonald's Big Mac meal has gone from $7.29 in 2019 to over $9.29 in 2024. Egg prices are even more volatile, with an increase of about 170% between December 2019 and December 2024. The term 'affordability' has become the dominant economic concern. In the NPR/PBS News/Marist poll, 70% of Americans said that housing costs in their area are not 'affordable' for an average family, a sharp increase from 45% in June.
This dissatisfaction is already showing up at the polls. In last year's mayoral election in New York City, Democratic State Representative Zohran Mamdani won on a platform to make the city more affordable. Democratic candidates also took the governorships in Virginia and New Jersey by focusing on easing living costs.
With the midterm elections in November approaching, over 30 Republican representatives have already announced they will not seek re-election. Political analysts increasingly predict a Republican defeat and a possible lame duck period for Trump.
Three scenarios, no easy path
The intersection of monetary policy and elections leads to three possible scenarios for 2026—none of which give Trump everything he desires.
Scenario 1: Inflation remains high. Trump faces political risks, could lose the midterm elections, and end up in a lame duck situation. But high inflation also means the central bank has no basis to cut rates. Trump's weakened position also reduces his ability to pressure the central bank.
Scenario 2: The economy cools sharply. Trump is hit even harder politically as voters punish him for a weaker economy. At the same time, the central bank has a clear basis to cut rates to support growth.
Scenario 3: Soft landing with moderating inflation. Trump's political position may improve as economic concerns wane. But when the economy is doing well, the central bank has little reason to cut rates.
In none of these scenarios does Trump achieve both political strength and lower interest rates. The two goals are in conflict.
The data that determines everything
Upcoming economic indicators will be crucial for both the central bank's policy and Trump's political fate.
Consumer Price Index (CPI): A decline would strengthen the case for rate cuts and give Trump political breathing room. An increase would constrain the central bank and heighten voter dissatisfaction with the administration.
Producer Price Index (PPI): As a leading indicator for consumer prices, a falling PPI will signal a future moderate CPI. A rising PPI may indicate that price pressures from tariffs and taxes are surfacing.
Employment data (NFP, unemployment): A weaker labor market increases pressure on the central bank to cut rates—but will also damage Trump's economic reputation. Stabilized employment gives the central bank confidence to maintain a cautious approach.
Conclusion
The central bank signals one rate cut in 2026. Hawks like Paulson suggest that it may not come until the second half of the year. Still, the market is pricing in two to three cuts, hoping that Trump's pressure and Powell's departure will ultimately lead the central bank to ease tightening.
But here lies the paradox: persistent inflation undermines Trump's political position, which in turn reduces his influence over the central bank. The same conditions that make interest rate cuts politically desirable for Trump also make them economically unjustified—or deprive him of the ability to demand them.
"It's the prices, stupid" applies to Trump, the central bank, and market participants. Ultimately, it is inflation and employment data that will simultaneously determine the path ahead for U.S. interest rates and the outcome of the midterm elections in November. Trump desires both political survival and lower rates, but the economy is unlikely to grant him that luxury.