What could revive 2026 Fed cut prospects?

Greatly improved labor market data and elevated inflation have forced a major repricing of Fed policy, with investors anticipating a rate hike by year-end. While we currently see the Fed on hold for an extended period, there are multiple plausible scenarios that could put 2026 rate cuts back on the table.

The marked improvement in payroll employment (May: 172K) since March means the Federal Open Market Committee’s (FOMC) attention has turned toward the inflation side of the dual mandate. The resulting hawkish tilt would therefore need to be directly and meaningfully challenged by a combination of factors. The more of these boxes get checked—and the sooner they are—the more likely that a rate cut can still materialize in 2026.

Possible triggers for a dovish U-turn

• A decisive end to the Iran conflict that removes worries over future oil price spikes: This would dramatically improve sequential inflation, remove the risk of broader spillovers, and practically guarantee favorable base comparisons for spring 2027 inflation readings. In turn, this allows the FOMC to more easily “look through” the energy price shock
• A visible cooling in labor market indicators, marking the recent upturn as a temporary bounce: This could involve slower job gains (especially if accompanied by sharp downward revisions to prior data), sustained rise in jobless claims, and/or an uptick in the unemployment rate.
• Loss of consumption momentum: Declining real household income growth accentuates the anticipated moderation in consumer spending growth, crimping GDP performance in the second half of the year. Pricing power remains constrained; evidence of margin compression broadens.
• Financial markets volatility, driven by AI or elections/policy concerns: A broad-based market selloff tightens financial conditions very rapidly and invokes supportive Fed intervention.

We see #1 and #2 above as the most likely facilitators of a 2026 rate cut. Concomitantly, we see worries about a loss of Fed independence as exaggerated and having no bearing on near-term policy direction. At the time of writing, news headlines about a possible “great settlement of war” with Iran suggests #1 could be achieved relatively quickly. Conflicting signals in the labor market data suggest #2 could materialize as well.

Conflicting labor market data argues for caution

Labor market data is sending mixed signals.

Take, for example, the growing divergence between the payrolls and household reports. Compared with the January levels, the payrolls report shows a cumulative employment gain of 409k, whereas the household report shows a cumulative loss of 326k, a sizable discrepancy. While it is normal for these two measures of employment to differ due to different target samples, the existence of multiple job holders, etc., the magnitude of the divergence cautions against taking the payrolls data fully at face value. 

Another puzzling contradiction exists between rising job openings and business and consumer survey data that indicates tepid hiring intentions and tepid labor market conditions overall. Specifically, job openings at firms with less than 50 employees have supposedly surged recently, although existing small firms report low hiring intentions and improved ability to fill open positions. One explanation here could be that more new businesses are being created and drive job openings, but they are not properly represented in existing business surveys. That being said, consumer survey measures (such as the Conference Board labor differential) and worker behavior (such as quits) indicate a weak hiring environment.

Finally, we are not particularly reassured by the low unemployment claims of the past few months. In fact, we find them quite puzzling. The retreat in continuing unemployment claims, even as the unemployment rate itself is nearly a full percentage point above its cyclical low, defies the historical pattern (Figure 3). We suspect other factors such as changes to qualifying requirements, indirect impact from immigration enforcement, and some residual seasonal adjustment issues could all contribute to the divergence.

Oil price shock seems contained

Despite sharp increases in (particularly short-term) inflation expectations in the University of Michigan consumer sentiment survey, we see limited scope for second-round effects from the energy price shock. Real personal disposable income is declining on a YoY basis and delinquencies are hitting new multi-year highs (Figure 4).

While overall consumer spending remains resilient, pricing power is weak as strains that have been percolating into the lower-income consumer segment for some time have become more acute. Recent news about some companies rolling back price hikes to revive demand illustrates this dynamic. In other words, the shock is more likely to be absorbed in company margins than passed on to consumers, weakening the case for broad, self-reinforcing inflation pressure. This would especially be the case if we get a resolution to the Iran conflict soon. Tariff refunds may also provide a welcome cushion, helping firms absorb at least some of the higher energy costs.

Where does this leave the Fed?

For now, the Fed remains firmly on hold. Not only is the data flow sending mixed signals, but the change in Fed leadership further reduces the likelihood of any near-term action. This is a very reasonable position, and our baseline forecast now no longer incorporates rate cuts in 2026. Nevertheless, should some of the dynamics highlighted above materialize, the FOMC may yet deliver a cut.