Fed Rate Cuts in 2026? How an Oil Shock Is Complicating the Outlook

Valentina Djeljosevic: It seems like the Federal Reserve hasn’t caught a break lately, and now it’s dealing with the economic shock of another war. With Fed Chair Jerome Powell saying the full effects of the Iran war are still uncertain, the Fed left rates unchanged for a second straight meeting. Instead of asking a Magic 8 Ball for answers, I have Preston Caldwell here. He’s a senior US economist for Morningstar Investment Management. Nice to see you, Preston.

Preston Caldwell: Hey, Valentina. Thanks for having me.

Will the Fed Cut Interest Rates in 2026?

Djeljosevic: So, most Fed officials are still predicting at least one rate cut this year. But as Powell said, the economic shocks from the war are not clear yet. So, could the Fed stick with a wait-and-see approach and leave rates alone for the rest of this year? How has your forecast changed, Preston?

Caldwell: I think in the short run, they’re definitely going to wait and see, at the very least. It’s important to remember that these projections that the FOMC members offer for the future path of the federal-funds rate are just projections. They’re not a commitment in any way, shape, or form. Sometimes the Fed will make a commitment to embark on a certain policy path like we saw back in 2022 when they made it very clear they were going to raise rates meeting after meeting, but that’s not the norm most of the time. And right now, the Fed is giving virtually no forward guidance. They’re saying that there’s a variety of events that are playing out right now that are outside of our control, and we’re going to have to wait to see the results of those events before we can tell you anything about where monetary policy is going to go.

And some of the reporters tried to push Powell, saying, “Well, if this scenario plays out, will you do this or vice versa?” But he really wasn’t keen to play that game because there are just too many unknowns right now. So, we’ll just have to wait and see what happens. And the range of possibilities certainly includes no rate cuts in 2026. The market is starting to inch closer to that direction. Back in January, the market had priced in two rate cuts for 2026, and that, as of yesterday afternoon, was pared down to one and edging close to zero rate cuts in terms of market expectations. That seems to be moving closer to the consensus view right now.

As Fed Holds Steady, Oil Spike Has 2026 Rate Cut Expectations Shrinking Fast

Both the bond market and Fed officials now signal just one move to lower rates this year.

Are We Back to 1970s Stagflation?

Djeljosevic: Now we’re going to talk about the word stagflation. It keeps popping up, but Powell said it just doesn’t apply right now. So, Preston, remind us what stagflation is and why it makes economists uncomfortable, and also tell us whether you agree with Powell.

Caldwell: I would say compared to a recession, which there’s no hard-and-fast definition of recession. I would say stagflation’s even more of a fuzzy category, but broadly it’s defined as a regime where inflation is higher than normal or its recent history. And GDP growth is, if not in a full-blown recession, it’s weaker than normal, which is odd, right? You think about a supply-and-demand graph and GDP and inflation, and generally what we see in the economy are shocks in the demand curve, which result in inflation being strong with GDP growth is also strong. So, kind of coming out of the pandemic is a good example of that. The economy was growing very fast, recovering from the pandemic and with the fiscal stimulus, and that also led to overheating. Inflation ran high. But this is a different scenario, this kind of veering into a stagflationary scenario that we’re looking at right now, where, because of a negative supply shock, GDP growth will, if anything, decelerate while inflation is certainly going to accelerate meaningfully over the next year.

Now, I take Powell’s point, and I kind of agree that it’s hyperbole to compare anything that’s going on today to like what we saw in the 1970s, for example, when unemployment was at times 6%, 7%, 8%, while inflation was 8%, 9%, 10% at the same time, thinking about at the very end of the decade there, significantly above current levels on both the inflation and the unemployment side. That was really true stagflation where the economy was operating significantly below potential and yet inflation was at very high levels at the same time. That’s not really what we’re looking at today, obviously. We’re looking at a mild deceleration of GDP growth, unemployment not likely rising above 5%, and inflation moving into the 3 to 4% range perhaps this year, but not anything like the 1970s for a variety of reasons.

Djeljosevic: So, we’re not seeing that double whammy like there was back then.

Caldwell: Well, it is a double whammy. It’s just the magnitude; it’s just the degree to which that’s the case is much smaller.

Labor Market vs. Inflation

Djeljosevic: Right. OK. Speaking of double whammy, with the weakening jobs picture and the worsening inflationary pressures due to the Iran war, do you think the Fed is now more worried about jobs or inflation, and are they really between a rock and a hard place like some people say?

Caldwell: This is directly connected to what we were just talking about. So normally the Fed faces demand shocks like the Great Recession, for example, or the pandemic to a great degree was a demand side shock. And the implications of that for the Fed are very straightforward. Loosen monetary policy. If it’s a negative demand shock, if it’s a positive demand shock, you tighten monetary policy. If there’s a boom, like the AI boom, for example, because those kinds of shocks, demand shocks tend to push up GDP growth and inflation at the same time. Whereas the supply-side shock does the opposite. What we’re seeing right now is weakening GDP growth while it pushes up inflation. And weakening GDP growth means weakening the labor market, therefore it’s pushing the two prongs of the Fed’s dual mandate in opposite directions. That’s what we get with supply-side shocks is that they always put the Fed in a bind. And depending how large they are, they can put the Fed into a very big bind.

Now, an interesting aspect here, too, obviously, is that the labor market was weakening in 2025, even before getting into the shock, although this happened at the same time that labor supply was contracting due to reduced immigration. And so it’s been hard to untangle exactly how much of that decrease in job growth is truly an increase in slack in the labor market and a drifting away from the Fed’s full-employment mandate as opposed to just a natural decrease due to lower labor supply growth. But I think most Fed officials are concerned enough, and I have been, in my assessment, thinking that the labor market has weakened over the past year a bit, to think it’s appropriate to engage in the rate cuts that they did last year.

So, they cut rates by 75 basis points after 100 basis points in cuts the year before, and I do think that that is appropriate. But going forward, I think it’s very clear that this inflation shock is of such a large magnitude, and also given that they’ve already brought rates much down more to a neutral level, that it’s now appropriate for them to stand firm and not loosen monetary policy even further, despite the downside risks to the labor market. I think that’s why most are expecting the Fed to keep rates steady this year and not cut further.

Could a New Fed Chair Change Interest Rate Projections?

Djeljosevic: We went back to the ’70s, and now let’s fast forward to June. Regardless of whether Fed chair nominee Kevin Warsh takes over or Powell has to stay on for a while, how do you think the Fed will look different in the second half of the year, and could that change in leadership also change their forecast of one rate cut in 2026?

Caldwell: I really think it’s too soon to tell. We’re just going to have to see what Warsh is going to do once he comes into office. I mean, look, he’s made perhaps certain promises to the president in order to get this job, but we know that whatever promises of loosening monetary policy he’s made, his entire past history has been as a monetary policy hawk, generally agitating for tighter monetary policy, that is higher interest rates than others would. And in particular, agitating for less quantitative easing. That’s been a big policy of his, but it really doesn’t matter. It doesn’t really matter whether, in my view, whether you lean on the federal-funds rate or the balance-sheet policy; those are just two substitutes for each other. So either way, he’s pushing for tighter monetary policy, and he has in the past philosophically. And to me, that’s going to predominate probably once he becomes chair.

And so you balance that with the promises that he’s made, perhaps to get the job. And I think it’s a wash overall. On net, I don’t expect policy to get either looser or tighter once he comes in to the chair role. And keep in mind, in terms of actually setting monetary policy, he’s just one voter among 14 on the FOMC.

Djeljosevic: That’s a great point. Well, Preston, that wraps it up for today. Thanks so much for being here.

Caldwell: Thank you so much, Valentina.

Watch High Valuations, Higher Stakes: We’re Expecting Volatile Markets in 2026 for more from Preston Caldwell.