Will Interest Rates Fall More in 2026? Our Latest Forecast

Key Takeaways

• The Fed cut interest rates by a quarter point, as expected, but there were dissents in the final vote.
• If we look all together, we expect two rate cuts next year, which is one more than the Fed.
• A factor that could cause rates to be more than expected is any abrupt deflating of the AI boom.
• Tariff policy could cause fewer rate cuts because, if they raise them again, it would further add to the inflationary impulse.
• The Fed chair says that interest rates are well positioned within the neutral range. It’s a very important metric that the Fed is always focused upon because, ultimately, that’s the best guide to where interest rates are likely to end up in the long run.

**Ivanna Hampton: **Tension is building between the Federal Reserve’s two goals. Inflation remains elevated, while the job market is showing signs of weakness. That showed up in the Fed’s final interest rate decision of the year. They’re closing out 2025 with three straight interest rate cuts, but pointing to even fewer in 2026. Joining me is Preston Caldwell, who’s a Senior US Economist for Morningstar Investment Management. Good to see you, Preston.

**Preston Caldwell: **Hey, Ivanna.

What Does Division at Fed Over Interest Rate Cuts Signal to Investors?

**Hampton: **So the Fed cut interest rates by a quarter point, as expected, but there were dissents in the final vote. Two committee members favor leaving the rates the same, while one wanted a deeper cut. What does that signal to you?

**Caldwell: **Well, you know, it’s interesting, because originally, I mean, this meeting was supposed to be something of a nail biter. If you look at the market expectations that were priced in as recently as mid-November, it was thought that it was more likely they wouldn’t cut. But then some Fed members kind of came out and telegraphed their intentions to go ahead and proceed with another rate cut. So, we ended up coming into this meeting, as of yesterday, with a 90% probability of a cut. But at the same time, with the dissents and some other language coming out of Powell and the committee, they’re setting themselves up for a pause right now. So we have two members dissenting on record in favor of not cutting this month, this meeting. And if two members are explicitly dissenting, then you’ve got others who are probably also dissenting but not coming forth officially with it yet or having doubts about further cuts at the very least. And Powell has said that it’s time to move into wait-and-see mode and to examine the new data that comes out before it starts proceeding with more cuts. I mean, the Fed now has cut by a cumulative 1.75 percentage points since September 2024, when it began this rate-cut cycle. So rates are still above where they were before the pandemic. We’re in the target range of 3.50 to 3.25. And before the pandemic, we were averaging 1.7% over 2017 and 2019. But we’re not at that restricted level that we were from mid-2023 to fall 2024, when rates were well over 5%. So we’re at a more comfortable area now and the Fed can slow down a lot, I think. And I don’t expect them to cut in their January meeting.

Should the Fed Make Larger Rate Cuts in 2026?

**Hampton: **Well, the Fed is forecasting one interest rate cut next year. How does that compare to your forecast, and what would warrant trimming rates more or less?

**Caldwell: **So if we look all together, so I expect two rate cuts next year. So that’s one more than the Fed. But altogether, through 2027, I expect an additional three rate cuts that year. So that would be five rate cuts altogether in 2026 and ’27 by our forecasts, versus just two expected over that two-year period from the Fed. So that’s another 75 basis points in cuts compared to Fed expectations, which is a pretty significant divergence by that time. And that’s about the same for the market. The market is about in line with the Fed. And my view is that the natural rate of interest in the economy is still closer to where it was before the pandemic. And that’s driven by long, slow-moving factors like demographics, aging demographics, and a slowing rate of trend rate of economic growth. And then we’ve had some factors that, since the start of the pandemic, like the excess savings, that have helped to sustain higher interest rates, but those factors are increasingly fading. For example, the housing market, despite the rate cuts that we’ve seen, it seems to continue to weaken, which means I think that homebuyers are getting more and more impatient with high interest rates and elevated home prices, which suggests to me that further rate cuts might be needed just to keep the housing market from declining further. Now, there’s a lot of uncertainty around that. And, frankly, my conviction in my own views is somewhat diminished just because the data is quite stale right now. So we still don’t have third-quarter GDP data yet. So getting that kind of full picture of the economy, we do have some data points for the second half of this year. We don’t really have the full picture that we would like to see right now. So I expect to update my views significantly once I get that Q3 GDP data and some other data points.

But as far as factors that could cause rates to be less or more than expected, I mean, as far as more than expected, in line with our view, as opposed to the Fed’s/market view, I think any abrupt deflating of the AI boom would clearly call for more rate cuts, because AI has contributed the lion’s share of GDP growth over the last year. Both through business investment directly, but also indirectly through the fact that the stock market has continued to rise. And that’s been a big prop to consumer spending. And so, if that runs in the other direction, that could entail, that could require a large amount of Fed monetary easing to offset that negative factor for aggregate demand. But as far as much fewer rate cuts, and even some possibility of rates not being cut at all or even heading back up again, I think, there, tariff policy is the key possibility there, where, even if tariffs maintain at current levels, there’s still the possibility that we get much more pass-through of tariffs into consumer prices. It’s still the case right now that US businesses are paying for the lion’s share of the tariffs, and they’re eating that. But if they seek to pass more of that on to consumers, then that could cause more inflationary pressure. And perhaps that could also propagate through other parts of the economy, too, as goods inflation goes, causes more services inflation. And, of course, if tariff rates actually move higher, who knows where they could go? They’re heading, it looks like they’re heading right down for right now, but if they start heading higher again, then that would further add to the inflationary impulse. So there’s definitely some credible scenarios where rates could move, could be much higher or lower than expected in the next year or so.

How a Neutral Interest Rate Affects Lowering Inflation and Strengthening the Job Market

**Hampton: **The Fed chair says that interest rates, they’re well positioned within the neutral range. Can you explain why that’s significant and what would it mean while trying to bring inflation down and strengthening the job market?

**Caldwell: **The neutral rate of interest is a level that, such that if interest rates are at that level for an extended period, then it should stimulate the economy just enough such that you have about full employment while inflation is in line with the Fed’s 2% target. And so it’s just kind of that goldilocks zone for where the economy is. It’s not overheated, but it’s not in any way depressed. And in that, that neutral rate, it depends on a lot of factors like, what’s the productivity growth rate—the underlying productivity growth rate—in the economy, which can drive the appetite to invest more? What’s the, as I alluded to earlier, what’s the—is the population growing quickly? Is it young, or is it growing more slowly and aging? Because the latter factor can create declining demand to invest, and that puts downward pressure on the neutral rate. If you have a slow growing population, you don’t need to build as many homes and infrastructure and so on. So in assessing that neutral rate is difficult because it has to be estimated. It can’t be observed directly. It’s just basically saying, if we look over the historical period, what would have been the interest rate that would have kept the economy in that balanced state of full employment with inflation in line with targets? So there’s disagreeing opinions about where the neutral rate is.

But most, if you look on the FOMC, among the committee members who set monetary policy, the median participant thinks the neutral rate is about 3%. So based on that, we’re very close to neutral right now, with our target range of 3.5% to 3.25%. Only a little over 50 basis points above that 3% neutral level. And as I’ve stated, I do think the neutral rate is a fair bit lower, probably closer to the average interest rate before the pandemic. The federal-funds rate averaged 1.7% over 2017 and ’19, as I said. The neutral rate has trended down for decades. So in around 1980, the neutral rate was, and this is in real, not nominal terms, by the way, the neutral rate at 1980 was probably at 4% or 5%. So it was much, much elevated, and it’s probably fallen by around as much as 400 basis points over the last four decades, just driven by the aging of the population, the slowing trend rate of economic growth, perhaps rising inequality, which has boosted the supply of savings, and some other factors. So it’s a very important metric that the Fed is always focused upon because, ultimately, that’s the best guide to where interest rates are likely to end up in the long run. Because the Fed wants to set rates in line with their neutral level in order to achieve its goals.

**Hampton: **Well, Preston, thank you for your time today.

**Caldwell: **Well, thanks a lot, Ivanna. Great to talk with you, as always.

Watch Investors First: 2026 Market Outlook for more from Kunal Kapoor and Preston Caldwell.