The Federal Reserve's own signal that monetary policy is now close to a neutral level has raised the ceiling of expectations for further interest rate cuts next year, suggesting that markets should anticipate tightening rather than rescue, paving the way for fixed income, rather than aggressive easing, to do most of the heavy lifting in investment portfolios unless an economic recession appears.
The Fed's 25 basis point cut at the December meeting - the third this year - brought interest rates to levels that policymakers now see as close to neutral, a setting that neither stimulates nor restricts economic growth. With policy now reaching a "broad range of estimates of its neutral value," Federal Reserve Chair Jerome Powell said the central bank is "well-positioned to wait and see how the economy evolves."
Fed division near neutral level a warning sign
Periods when policy is close to neutral typically require a unified Federal Open Market Committee, as mistakes in either direction can have significant consequences. Excessive cuts risk reigniting inflation, especially with many expecting fiscal policy to become more expansive next year under President Donald Trump.
However, the recent meeting highlighted the growing divisions among Fed officials, raising questions about policymakers' confidence in their own forecasts. The Fed's updated economic projections summary outlines a smooth path for the future: growth remaining above 2%, a stable labor market, and inflation gradually returning to target.
"On paper, that looks great," said Jim Beard, chief investment officer at Plant Moran Financial Advisors, in an interview with Yassine Ibrahim of Investing.com. "The reality is achieving that will be much more difficult. You have to take these expectations with caution," he added.
Markets vs. the Fed: Who is betting more?
Markets viewed Powell's tone as a signal that further easing is still possible, pricing in up to two interest rate cuts next year, according to Investing.com’s Fed Rate Monitor Tool. In contrast, Fed officials continue to project only one cut despite the apparent lack of consensus within the committee.
But whether it’s one cut, two cuts, or no cuts at all... the "key message there is: don’t expect the Fed to do more in the absence of a recession," Beard said.
Wall Street itself is far from unified on what comes next. Macquarie's baseline is that a Fed interest rate cut in December could be the final step in the current easing phase, with its next policy ultimately shifting back toward tightening. In contrast, Morgan Stanley expects the labor market to remain weak until tariffs are fully passed and looks for an additional cut in January and April, noting that if employment data continues to hold up, more easing may require a clearer drop in inflation.
What to watch for in 2026
As policy approaches the neutral level and valuations rise in parts of the stock market, particularly among high-flying AI stocks, fixed income seems poised to play a more central role in investment portfolios.
"For investors who need to have a healthy allocation to fixed income, their fixed income portfolio is able to do more heavy lifting," said Beard, warning that selectivity is important.
"Credit is still priced aggressively in some areas," he added. "I will wait for a better opportunity to enter cautiously."
With attention focused on the neutral interest rate, another risk looms: that the Fed may ultimately have to shift completely away from easing.
"If the economy really takes off, and inflation ticks up a bit, and the Fed has to reverse course and tighten instead of cut," Beard said, "that would surprise the market
