Rate Cut Prospects Fade as Fed's Inflation Gauge Runs Hot and Q4 Growth Stalls

The Federal Reserve’s battle against inflation just got harder. New economic data released this week showed that the Fed’s preferred inflation measure came in hotter than expected while quarterly economic growth disappoints, pushing rate cut prospects further into the distance. The combination has left markets scrambling to recalibrate expectations for when the central bank might begin easing policy, with Treasury yields and equity futures showing the tension investors now face as they navigate trade uncertainty and geopolitical risks tied to political developments.

Core PCE Inflation Stays Sticky Despite Economic Slowdown

The core Personal Consumption Expenditures (PCE) price index — the Federal Reserve’s primary tool for tracking underlying inflation — printed at 0.4% month-over-month, running hotter than forecast. On an annual basis, core PCE held firm at 3.0%, well above the Fed’s 2% target and signaling that price pressures remain entrenched despite broader economic deceleration.

Breaking down the components reveals a nuanced picture. Core goods inflation advanced 0.43% month-over-month and 1.97% year-over-year, while core services—a critical measure given its size in the economy—rose 0.33% month-over-month but accelerated to 3.3% on an annual basis. Healthcare expenses particularly boosted the services component.

Notably, portfolio management fees jumped 1.78% during the month, an outsized move that tends to correlate with equity market swings and may overstate true underlying inflation momentum. However, the market-based core PCE measure that policymakers closely monitor ticked up to 2.7% annually, climbing from 2.5% previously—a shift that likely caught Fed officials’ attention.

Fourth-Quarter Economic Growth Disappoints Markets

U.S. real GDP expanded just 1.4% in the fourth quarter, a dramatic deceleration from the prior quarter’s robust 4.4% gain and worse than economists had anticipated. The slowdown reflects a complex mix of headwinds that paint a less robust economic picture heading into 2026.

Breaking down the data, goods spending actually contracted 0.1% while services spending grew a healthier 3.4%, propped up by elevated healthcare outlays. Private domestic investment posted solid 3.8% growth, but government spending collapsed 5.1%, dragging nearly 0.9 percentage points off overall GDP growth. Federal spending declined 16.6% during the quarter due to residual shutdown impacts from the prior period.

A brighter spot: private sales to final domestic purchasers—a metric the Fed follows closely as a gauge of underlying demand momentum—expanded 2.4%, suggesting that consumer purchasing power remains moderately resilient beneath the headline slowdown.

Policy Rate Cut Odds Get Pushed Further Back

The disappointing inflation and growth data have forced markets to pare back expectations for near-term Federal Reserve rate cuts. According to CME Group’s FedWatch Tool, rate cut probabilities have shifted meaningfully. What once looked like an imminent easing cycle now appears to be receding into the second half of the year as sticky inflation and a resilient labor market constrain policy flexibility.

Market odds for rate cuts have compressed across the policy timeline, with investors now banking on extended periods of unchanged policy before cuts materialize. The baseline scenario emerging from trading desks suggests the Fed will hold course through the spring, with actual rate cuts becoming more probable only after inflation shows clearer and more sustained progress toward the 2% goal.

How Markets Are Responding

Equity futures declined 0.3% following the data releases as investors reckoned with the delayed policy outlook. The benchmark S&P 500 currently trades beneath its 50-day moving average—a technical level that had briefly held earlier in the week before giving way. Treasury yields, meanwhile, inched slightly lower as bond markets adjusted to diminished near-term rate cut prospects.

The market mood reflects genuine uncertainty about the timing and magnitude of future policy adjustments. Investors are simultaneously weighing a slower-growth backdrop against inflation that refuses to fade toward the Fed’s target, creating a difficult calculus for asset allocation decisions.

The Bigger Picture: Multiple Crosscurrents Collide

Beyond the domestic data, markets must contend with expanding trade deficits—December saw the gap widen to $70.3 billion—alongside geopolitical tensions and potential shifts in trade policy. A possible Supreme Court ruling on tariff authority adds another layer of uncertainty to the outlook.

The core challenge for policymakers and investors alike remains stark: inflation sits stubbornly above target, growth is cooling, and the traditional policy toolkit offers limited attractive options. Unless price momentum shows material and sustained improvement in coming weeks, expectations for a meaningful easing cycle will likely remain pushed back, keeping rate cut prospects muted for now.