U.S. Fed could find itself in a bind as it sets the stage for Powell’s successor

The Marriner S. Eccles Federal Reserve Board Building, Friday, June 19, 2015, in Washington.

WASHINGTON — The U.S. Federal Reserve’s meeting this week will begin to set expectations for President Donald Trump’s upcoming nominee to lead the central bank, potentially leaving policymakers in a bind between inflation concerns shared broadly and Trump’s demands for interest rate cuts.

A quarter-percentage-point rate cut seems a given at the two-day meeting that ends on Wednesday, but language around that decision and accompanying economic projections will show whether the next chair will take over a body primed against further cuts or more open to argument and with a more dovish near-term outlook.

Trump wants lower borrowing costs in particular to boost the housing sector as a way to address broader concerns about affordability that could be central to midterm elections. But delivering on that could pose risks for the next Fed chair, with forecasters expecting resilient growth next year, sustained consumer spending from enhanced tax refunds and, as a result, more persistent inflation.

“Regardless of who leads the Fed, in the first order monetary policy is determined by economic conditions,” James Engelhof, chief U.S. economist for BNP Paribas, said during a 2026 outlook call, which anticipates resilient growth and persistent 3 per cent inflation leading to just one rate cut next year following the one anticipated on Wednesday. “The data will suggest little need for aggressive rate cuts.”

That could put the next Fed chair into the same box Jerome Powell has occupied - pressured by Trump to cut rates in an economy more in need of restraint than stimulus. With midterms potentially hinging on affordability issues and the labor market, pressure on the Fed could mount and tradeoffs intensify.

Cutting rates too far may stoke demand, boost hiring, and make mortgages more affordable, while also lifting inflation and, in the extreme, shifting public expectations in a way that makes it harder for the Fed to hit its 2 per cent inflation goal - an outcome current policymakers have sworn to avoid.

Deciding on the least risky path has already divided the Fed, leaving the potential for multiple dissents to this week’s rate decision. New policymaker projections for rates, inflation and unemployment for the coming year to be released with the statement could show how likely those divisions are to remain through the leadership transition. In September policymakers at the median expected only one quarter-point cut in 2026, with the Fed’s rate ending next year in the 3.25 per cent to 3.50 per cent range, possibly still slightly restraining the economy.

PROJECTIONS IN THE DARK

Powell’s term as chair ends in May. Trump has said he will nominate a successor early next year, with a Senate confirmation vote to follow.

This week’s projections will be hampered by the 43-day government shutdown during October and November. The most recent government reports on the labor market and inflation were for September, leaving policymakers to fill in the gaps with private estimates, their own surveys, and conversations with business and community contacts.

Data scheduled after the Fed’s meeting could help clarify whether the economy is tilting towards weaker employment or higher inflation, and thus help ease the policy divide. But it could also extend the current standoff if, as forecasters currently expect, the unemployment rate remains relatively low and inflation holds above target.

A recent Reuters poll of economists anticipates economic growth in 2026 of around 2 per cent, slightly above most estimates of the trend rate, with underlying inflation stuck appreciably above the Fed’s target at 2.8 per cent, and the unemployment rate averaging 4.4 per cent, where it was in September.

That would provide little relief for those Fed officials, particularly a group of regional reserve bank presidents, who say they want to be sure inflation - above target for nearly five years - is set to fall before they lower rates much further.

Tim Duy, chief U.S. economist for SGH Macro Advisors, said he expects a “hawkish cut” from the Fed this week, after a “contentious battle.”

After that “policy rates will be sufficiently close to neutral that the bar to additional cuts will rise,” Duy said, referring to the rate seen as neither encouraging nor discouraging economic activity, thus neither boosting nor leaning against inflation.

RISKING A BACKFIRE

Determining the neutral rate, already notoriously difficult, may be tougher now with the economy still working through the tariff hikes, immigration restrictions and other Trump policies that challenge forecasters already trying to assess a possible labor and productivity shock coming from the artificial intelligence boom.

In addition, Trump’s Fed Board of Governors appointees have sketched out a variety of arguments for continued cuts, with Governor Stephen Miran arguing rates should be slashed to a level most of his colleagues would see as aggressively stimulative.

Meanwhile, Trump economic adviser Kevin Hassett, a top candidate to succeed Powell, speaks of a productivity boom driven by artificial intelligence, which if it does develop could lower inflation risks and allow lower rates, even if economic growth accelerates.

It’s part of a broader push for a more Trump-aligned and dovish Fed that includes Trump’s attempt to fire Governor Lisa Cook, an appointee of former President Joe Biden, and recent comments by Treasury Secretary Scott Bessent about possible changes to how reserve bank presidents are hired - a potential pressure point on a group that leans more hawkish for now.

How much that all translates into monetary policy remains to be seen, particularly if the economy remains largely on track and inflation proves persistent. If the Fed under a new chair does try to push rates too low too fast, it could backfire, said Nathan Sheets, global chief economist for Citigroup.

“If the Fed gets out ahead of itself and cuts more aggressively than the markets feel is justified, markets are going to say that’s inflationary” and push up longer-term rates, including for mortgages, even if the Fed is lowering its short-term rate, Sheets said. “If you get a Fed chair who is more closely related to the administration and wants to deliver a strong economy for the president, for the midterms, the way to do it is not to have the back end of the yield curve spike...That’s going to throttle the housing market.”

(Reporting by Howard Schneider; Editing by Dan Burns and Andrea Ricci)