All eyes will be on the Federal Reserve in 2026 with changes coming

2026 should be an interesting year for the Federal Reserve, with data again flowing and a new chair on the horizon with Jerome Powell's term expiring.

"After a period of data fog, there's some visibility on the Fed's potential path," said Magdalena Ocampo, market strategist at Principal Asset Management, citing the end of the government shutdown that interrupted the release of economic data through October into November.

Ignoring inconsistencies related to the shutdown, she said unemployment is at a four-year high, with core inflation near a four-year low. "Together, these trends reinforce the case for a more dovish policy approach," Ocampo said. She expects more than one rate reduction, "perhaps coming earlier in the year."

But uncertainty remains before the next Federal Open Market Committee meeting, as additional inflation and employment data will be released, she added.

"For now, we expect two rate cuts next year, likely in the first half, and, provided unemployment doesn't spiral, a resilient economy, cooling inflation and easier policy should be supportive for risk assets in the year ahead," Ocampo said.

Brian Rehling, head of global fixed-income strategy at Wells Fargo Investment Institute, expects two rate cuts in 2026, but warns with a new Fed chair coming, "we're going to have to watch things closely."

To push rates to below neutral levels, a new chair would have to build a consensus, Rehling said. A chair can't lower rates by himself, he would need more governors' votes, he added. It will be a "really unique dynamic."

Advice for bond buyers for 2026? "The bond market is a yield market," Rehling noted. "Adding some credit risk makes sense, but you don't want to get too far down the credit scale."

Traders expect further easing in 2026, KBRA Financial Intelligence analysts said, "as significant turnover in Fed leadership introduces added uncertainty to the policy outlook."

The disparity between the Fed's projection and fed funds futures traders "can be partially explained by the fact that the composition of Fed policymakers providing forecasts in the FOMC's latest projection materials is likely to change materially throughout first half of 2026," they wrote.

They note that Powell's term ends in May, but "he does have the option to remain on as a Fed governor until January 2028." Fed chairs usually leave once they lose the chair spot. "If Powell follows such precedent, it will create an opportunity for President Trump to not only select a new chair, but to also add yet another new governor to the board," they wrote.

The seat held by Gov. Lisa Cook could be in play, as the Supreme Court will decide whether she can be removed.

The possibility of changes at the Fed could create a panel "that thinks very differently from the current committee," according to James Knightley, international economist at ING.

As for policy, he said, "right now there appears little need for much more easing from the Fed given the economy is growing, unemployment is low, equity markets are close to all-time highs and inflation is closer to 3% than the Fed's 2% target."

But, Knightley added, "we suspect the inflation backdrop will become more conducive for interest rate cuts in the coming months, thus giving the doves the justification for further action."

Although tariffs remain an issue, he said, they have come "through more slowly and less forcibly than feared. This allows more time for disinflationary forces from lower energy prices, slowing housing rents and weaker wage growth to mitigate and, we believe, push inflation closer to 2% more quickly than the Fed is forecasting."

Still, he expects two 25 basis point cuts ? one in March and one in June.

If the Fed keeps rates slightly restrictive, as it plans to, "the 10-year yield may remain elevated relative to historical neutral levels," said Lawrence Gillum, chief fixed income strategist for LPL Financial (LPLA).

"However, any shift in the Fed's tone ? whether toward easing or a more neutral posture ? could prompt a recalibration in market pricing, particularly if inflation continues to moderate and growth slows," he said.

"The Fed is projecting that the easing cycle is nearing its end" if you view its rate projections, Ryan Swift, U.S. bond strategist at BCA Research, said.

However, if one looks at Fed officials' economic outlook, "FOMC participants expect strong real GDP growth, falling inflation and a flat to-lower unemployment rate in 2026," he noted.

"If the unemployment rate doesn't cooperate with the Fed's optimistic forecast ? we strongly suspect it won't ? a dovish surprise to the Fed's 2026 interest rate projections is highly likely," Swift said.

If the Fed assumptions are correct, it's more complicated, he said. "In that case, we still observe a fairly wide divergence of opinions about appropriate interest rate policy for 2026. In fact, we observe more disagreement among Fed participants about appropriate interest rate policy than we do about the economic outlook."

Christian Hoffmann, head of fixed income at Thornburg Investment Management, said "Powell is likely going to become a lame duck fairly quickly," and if an announced replacement is made soon, it "introduces the concept of a 'shadow Fed,' with a prospective chair offering opinions or taking potshots from the sidelines."

The next chair will need to "establish credibility as a legitimate inflation fighter." Hoffmann said. "If they don't, they introduce volatility into the Treasury markets and create broad unease, which no one wants."

If the new chair seems too eager to please President Trump, "the existing Fed members are likely to view that person with skepticism," he said, which could hinder his ability to build consensus.

As for fixed income markets' outlook, Hoffmann said, "it's hard to expect significant outperformance from credit spreads given how tight they are. I think the risk there is to the downside, and for interest rate markets and Treasury markets, we should expect more volatility from what had been coming down."

Mike Goosay, CIO of global fixed income at Principal Asset Management, said, "the fixed income landscape presents a cautiously constructive backdrop."

Interest rates will gradually be lowered "toward a neutral level, projected to be around 3%," he said. These cuts will start midyear, Goosay added. "Market expectations already reflect a more accommodative approach to policy changes sooner than previously anticipated, as the Fed effectively balances its dual mandates of stable prices and full employment."

Rate cuts will create "potential for a steeper curve, which is consistent with prior easing cycles. Such environments typically lead to appreciation across the yield curve, offering investors opportunities to capture gains alongside income generation," he said.

"We remain moderately long in duration, emphasizing flexibility to respond to curve shifts and evolving inflation expectations," Goosay said. "Effectively managing exposure across both ends of the curve will be key to optimizing returns in this interest rate environment."

Mickey Levy, a visiting fellow at the Hoover Institution, expects Kevin Hassett to be the next Fed chair.

"Hassett's economic thinking tilts decidedly toward entrepreneurial supply side economics ? low taxes and less regulations and low interest rates ? but bends to meet Trump's preferences including tariffs and a clampdown on immigration (even though Kevin understands they are negative for the economy)," Levy said.

For a while, he said, "Hassett will be dominated by Trump's desires for lower interest rates."

But that "appetite for lower rates will be constrained by inflation and financial markets," Levy added. Should he push for lower rates, there will be dissenting votes, Levy said.

And while Hassett worked as a Fed staffer early in his career, Levy said "he will be considered an 'outsider' by the Fed establishment."

As such, he added, "change and uncertainty within the Fed will be a challenge, on many dimensions."