Federal Reserve's Inflation Outlook: Potential for Rate Cuts in Second Half

The President of the Federal Reserve Bank of Philadelphia, Anna Paulson, recently stated that if inflation continues to ease, the labor market remains stable, and economic growth stays around 2%, then a moderate further rate cut by the Fed in the second half of 2026 could be a reasonable option. This statement reveals the Fed’s complex assessment of the current economic situation—seeing hope for inflation relief while facing multiple policy adjustment dilemmas.

Balancing Inflation Relief and Policy Space

In her speech at the upcoming annual meeting of the American Economic Association, Paulson emphasized that inflation is gradually declining and the labor market shows signs of stabilization. She pointed out, “If inflation trends continue to improve, employment data remain stable, and economic growth stays around 2%, then a moderate adjustment to the federal funds rate later this year is likely to be a reasonable policy choice.”

Although the Fed has cut interest rates by a total of 75 basis points over the past three policy meetings, Paulson believes that current monetary policy remains “somewhat restrictive,” and this stance will continue to exert downward pressure on inflation. She stated that the restrictive monetary policies of the past and present will work together to steadily bring inflation back to the Fed’s 2% target. This reflects the Fed’s ongoing commitment to controlling inflation.

The Dilemma of Policy Under Labor Market Pressure

The core challenge for Fed policymakers lies in the complex changes within the labor market. Tightening immigration policies under the Trump administration have reduced labor supply, but the slowdown in labor demand has exceeded the decrease in supply, increasing labor market risks. Paulson admitted that the risks in the labor market “remain high.”

However, signs of stabilization in unemployment benefit claims provide some support for policy adjustments. Paulson emphasized, “Although the labor market is clearly under pressure and easing, it has not collapsed.” This suggests that employment conditions are still under control amid slowing economic growth.

Trade policies also significantly impact inflation, which Paulson is closely monitoring. She expects tariffs may keep inflation high through the first half of 2026, but by the second half, goods inflation should fall to levels consistent with the 2% target. This outlook leaves room for rate cuts in the latter half of the year.

Internal Divisions and Market Expectations Disparity

Within the Fed, there are clear disagreements about the policy path for 2026. An increasing number of officials prefer to keep interest rates unchanged until more data on inflation and employment are available. The median expectation among Fed officials is only a 25 basis point rate cut for the entire year, while investors generally anticipate at least a 50 basis point reduction. This 20-25 basis point difference reflects the market’s higher expectations for further easing compared to the official stance.

The government shutdown also complicates policy decisions. Paulson noted that the shutdown has disrupted economic data collection, making it more difficult to assess the current economic condition. Her economic outlook does not incorporate the latest unemployment rate data, but her core view remains cautiously optimistic about inflation trends.

Concerns Over Strong Economic Growth

In November last year, the U.S. unemployment rate rose to 4.6%, the highest in four years, but core inflation indicators improved simultaneously. Even more surprisingly, economic growth data exceeded expectations—Q3 2025 GDP growth reached an annualized rate of 4.3%, far above forecasts.

Paulson remains optimistic about this “strong growth and falling inflation” scenario but also recognizes the risks involved. She reiterated her previous view that artificial intelligence technology could significantly boost productivity. If this materializes, the Fed would not need to worry about high economic growth fueling inflation. However, she also admitted that policymakers cannot determine in real-time whether the acceleration in growth is due to productivity gains or other factors.

The Critical Role of Central Bank Credibility in Inflation Control

Recently, Paulson co-authored a paper emphasizing the crucial role of central bank credibility in curbing inflation surges. The paper pointed out that “inflation fluctuations over the past five years do not seem to have had a lasting impact on long-term inflation expectations.” This indicates that the Fed has successfully maintained market confidence in its ability to control inflation through past policy actions and communication.

Overall, Paulson’s statements reflect a cautiously optimistic stance from the Fed: inflation is gradually returning to a manageable path, but vulnerabilities in the labor market and internal policy disagreements require a careful approach to rate cuts. The policy adjustments in the second half of 2026 will ultimately depend on inflation trends, employment data, and actual economic growth performance.