Sticky Inflation Likely to Keep Fed on Hold Despite Weaker Economy

Key Takeaways

• Inflation rose to 3% in December, prompting the Federal Reserve to pause further interest rate cuts.
• Fourth-quarter GDP growth slowed to 1.4%, significantly below the 2.8% consensus estimate, due to the government shutdown.
• Analysts expect inflation to decline in 2026, supported by softening rental prices and fading tariff pressures.

An uptick in inflation in December validates the Federal Reserve’s pause in cutting interest rates, analysts say, even though economic growth data at year-end looked disappointing.

Fed officials received two varying stories of the economy in Friday’s data releases. One pointed to weakening: Real GDP grew by 1.4% in the fourth quarter, dragged down by a weeks-long government shutdown. Growth was sharply below consensus estimates of 2.5%.

The other pointed to hotter trends. The Fed’s preferred inflation gauge rose to 3% year-over-year in December, up from 2.8% in November. The reading suggests progress toward the central bank’s goal of 2% may be stalled.

“The higher inflation reading justifies the Fed moving to the sidelines and holding the policy rate steady for a while longer,” wrote Kathy Bostjancic, chief economist at Nationwide.

Not that the Fed may stay there forever. Bostjancic expects inflation to keep marching back down in the months ahead, since rental prices are softening and tariff-driven inflation is fading. That could open the door for two rate cuts by year-end, Bostjancic wrote.

Why This Matters

Sticky inflation could delay further rate cuts, affecting borrowing costs for consumers and businesses. At the same time, slowing growth raises questions about how long the Fed can stay on hold.

The Fed lowered interest rates three times in 2025, bringing its benchmark rate down to 3.5% to 3.75%. But some officials at the Fed are wary of cutting rates again until inflation is back to target.

“Looking ahead, I anticipate we’ll see progress on inflation this year,” Dallas Fed President Lorie Logan, one of the Fed’s more hawkish members, said this month. “But I am not yet fully confident inflation is heading all the way back to 2%.”

Optimism for 2026

The Fed tends to cut interest rates when the economy is softening—much as it did last year when job growth was stalling. But many analysts anticipate sunnier prospects for the economy in 2026.

“The core of the economy is resilient,” wrote Michael Pearce, chief U.S. economist at Oxford Economics. “With tariff pressures fading and tax cuts beginning to fuel an increase in capital spending, the economy will gather momentum in 2026.”

Consumer spending rose at a solid pace that’s “not indicative of a slowing economy,” wrote Richard de Chazal, macro analyst at William Blair. Stronger business investment in equipment is also a sign of an “unfolding capex boom,” de Chazal wrote, as companies step up their capital expenditures.

“From the Fed’s perspective, it will likely look through the noise from the shutdown, and see few signs of economic deterioration that would necessitate further rate cuts for the time being,” he wrote.

Others are a bit less optimistic. When excluding the shutdown impact, the economy’s momentum was solid but is also “likely to wane” this year, wrote Samuel Tombs, chief U.S. economist at Pantheon Macroeconomics.

Technology expenses continue to boost business investment, he wrote, pointing to an “ongoing divergence between tech-related sectors and the rest.” Residential investment fell by 1.5%, he added, marking the sixth consecutive drop in the last seven quarters.

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The rise in consumer spending is also “over-reliant on consumers saving less,” he added, rather than large wage increases driving up expenditures.

“Bumper tax refunds will lift consumption briefly this spring, but by mid-year it will be clear that spending has slowed amid still-weak employment growth and slower wage gains,” Tombs wrote.

That should help prompt a resumption in the Fed’s rate cuts, he said, even as officials “will continue to wait for further signs" of inflation returning to 2% before easing policy again.