Amidst a torrent of unsettling international and domestic events, the week ahead could be very consequential for the Federal Reserve. The FOMC will hold its first meeting of the year on Tuesday and Wednesday. While they will likely leave interest rates on hold, any dissents on that decision and their commentary on the economic outlook will provide clues to the direction of short-term interest rates in 2026 and beyond. In addition, this week the President is expected to announce his nominee for Fed Chair, the person who, presuming they are confirmed by the Senate, will lead the Fed over at least the next four years.
However, most importantly, the week ahead should provide guidance on Fed independence.
Two weeks ago, in an extraordinary statement and video, Jay Powell announced that the Fed had received subpoenas threatening a criminal indictment related to Powell’s testimony before the Senate Banking Committee concerning a project to renovate Fed office buildings. Powell asserted that the buildings’ issue was just a pretext and what this was really about was, and I quote, “…whether the Fed will be able to continue to set interest rates based on evidence and economic conditions – or whether instead monetary policy will be directed by political pressure or intimidation.”
Global investors will obviously be interested in further comments from Chairman Powell on this subject. So while it is important to consider what the Fed should do and will do this week, as well as who the President nominates to be the next Fed chair, the over-riding question is whether monetary policy will continue to be set by the Fed or whether the Fed will lose its independence, with monetary decisions effectively being made by the executive branch or Congress.
What the Fed Should Do this Week
In December, the Fed cut the federal funds rate by 25 basis points to a range of 3.50% to 3.75%. This followed similar cuts in September and October and left the funds rate 1.75% below its level of the summer of 2024. At this point, there is a strong case for the Fed taking no further action for some time.
First, the economy appears to be achieving steady economic growth. The Atlanta Fed’s GDPNOW model suggests a booming 5.4% real GDP growth rate for the fourth quarter of 2025. We believe that this is exaggerated by very volatile trade data and that, when the delayed 4Q2025 GDP report is released on February 20th, it will show growth closer to 2% annualized for the quarter and 2.4% year-over-year. Still, that is solid growth and, with bumper income tax refunds due to be paid out in the weeks ahead, consumer spending should continue to power the economy forward well into the second half of the year.
Of course, growth could slow, due to another government shutdown, or accelerate, due to the payment of so-called “tariff rebate” checks. However, the Fed will probably ignore these scenarios for now and, looking at growth, will have little reason to adjust interest rates in either direction.
Turning to the labor market, the unemployment rate fell from 4.5% in November to 4.4% last month and initial unemployment claims have been very low in recent weeks. Job growth has been sluggish in recent months and revisions to the payroll survey, due out in early February, and the household survey, due out in early March, could indicate even weaker job growth in recent months than initially reported. However, labor supply is being severely curtailed by a sharp reversal in immigration over the past year. While job growth isn’t strong, the labor market is tight in terms of the balance between supply and demand and it is this issue that should be paramount in guiding Fed policy.
The December CPI report showed year-over-year headline inflation of 2.7%, a modest improvement from the 3.0% seen in September. However, the government shutdown forced the Bureau of Labor Statistics to use partially outdated data on rental costs which suggests that the 2.7% year-over-year reading is underestimating year-over-year inflation by 0.1%, a situation that will only be remedied by April. In addition, feedthrough effects from tariffs imposed last year, combined with larger income tax refunds, could boost inflation to 3.5% year-over-year by June. Thereafter, inflation could fade. However, given that the economy is substantially closer to the Fed’s unemployment goal of 4.2% than their inflation goal of 2.0%, it's hard to argue that the economy needs further monetary easing now.
A second reason the Fed should hesitate to ease further is that interest rates are simply not that high.
In the 50 years before the Great Financial Crisis, the federal funds rate averaged 1.84% above year-over-year core CPI inflation. This makes sense - investors should expect to receive some positive real return for saving rather than consuming. However, we estimate that core CPI inflation will come in at 2.65% year-over-year for January so that the current effective federal funds rate of 3.64% implies a real yield of less than 1%.
Nor is this the only dimension of low interest rates. In the 50 years before the financial crisis, the 10-year Treasury bond yield averaged 6.79%, 0.87 percent higher than the federal funds rate. This too makes sense – investors should normally expect to be paid a better yield for lending money for 10 years compared to overnight. However, with 10-year yields currently at 4.23%, they are only 0.59% above the federal funds rate.
Finally, asset prices should give the Fed a reason to be cautious. While low interest rates in recent decades did little to boost economic growth, they did help fuel both the dot-com bubble and the housing bubble. With stocks surging for more than three years and credit spreads tight, the Fed has every reason to be cautious about adding further liquidity to already frothy financial markets.
What the Fed Will Do this Week
So much for what the Fed should do. What about what they will do?
Futures markets are currently pricing in just a 4% chance of a rate cut at this week’s meeting and a 20% shot of a cut in March. For the year as a whole, markets are pricing in one rate cut with an 80% shot of a second by this time next year.
Overall, this seems like a reasonable expectation - provided the Fed maintains the ability to set monetary policy based on economic conditions. It should be recognized, however, that if (1) the administration continues its tough stance on immigration, (2) the Supreme Court overturns some of the administration’s tariffs and (3) the Democrats win back control of the House in November, potentially ending further bouts of fiscal stimulus, both real economic growth and inflation could sink below 2% entering 2027, potentially setting the stage for further monetary easing.
In its press release, the FOMC may tweak the language around its assessment of the labor market to acknowledge a recently lower unemployment rate and lower unemployment claims but otherwise broadly maintain its messaging that economic activity is expanding at a moderate pace and that inflation remains somewhat elevated.
However, apart from this, the Fed’s written communications are unlikely to surprise. Governor Miran may dissent again in favor of a further rate cut but, if he does so, he will likely be alone, with all eleven of the other FOMC voting members favoring no change.
The Chairman’s press conference will be interesting, however, given the obvious political tension. Most likely, Jay Powell will try to focus on the economic outlook and the rationale behind current monetary policy. However, given his statement from earlier this month, he may well indicate his intention to stay on the Federal Reserve Board of Governors until his term as governor expires in January 2028, even after his term as Fed Chairman comes to an end in May of this year.
A Change in Personnel and Maintaining Fed Independence
This brings us to the issue of who will be nominated to be the next Fed Chair. The President, in his first term, nominated Jerome Powell for the job and apparently regrets doing so. He will therefore, presumably, nominate someone who he feels is more likely to follow his guidance. That being said, it would be unfair to presume that the nominee, whoever they turn out to be, will merely do the President’s bidding going forward. It is also possible that the Senate Banking Committee or the full Senate would reject a nominee that it felt was either unqualified for the job or willing to surrender Fed independence.
More importantly, however, it should be recognized that the very structure of the Federal Reserve mitigates against political interference. The 12 regional Federal Reserve Bank Presidents have always been somewhat independent of Washington and will likely maintain their independence going forward.
The seven Fed governors serve in staggered fourteen year terms, so one vacancy opens up every two years. Provided the Supreme Court blocks the administration’s attempts to fire Lisa Cook and Jerome Powell resists efforts to cajole him into resigning from the Board, the President will only have the opportunity to pick one Fed governor between now and 2028, namely the seat currently being occupied by Governor Miran.
This is not a guarantee of Fed independence. If the administration succeeds in its efforts to remove Cook and Powell from the board, it may feel emboldened to try to replace the other governors and it may succeed in doing so if the Senate acquiesces in that endeavor. However, there are too many “ifs” and “mays” in that statement to make it anything other than a long-shot scenario.
That being said, investors should not underestimate the importance of Fed independence. While the Fed has made many mistakes over the years, it has always, in my experience, tried to do only what it thought was in the interests of the long-term health of the American economy. The same cannot be said for policymakers elsewhere in Washington and investors would have every reason to fear the worst if the power to set monetary policy were transferred into the hands of those who, thus far, have only been stewards of the federal finances and fiscal policy.