Bank of America unveils surprising Fed interest rate forecast for 2026

Bank of America analysts now forecast the Federal Reserve will hold steady on interest rates through 2025 but project a 1% rate cut in 2026, influenced by recent CPI data showing a slight inflation increase to 2.4% year-over-year in May and a rising unemployment rate of 4.2%. Despite concerns over tariff-related inflationary pressures and rising layoffs, analysts believe the May CPI data reduces the risk of stagflation, potentially paving the way for rate cuts in 2026 if the labor market remains solid and inflation slows.

Analysis

Bank of America has revised its Federal Reserve interest rate forecast, now projecting rates to remain unchanged through 2025, followed by a cumulative 1% cut in 2026. This outlook is shaped by a complex interplay of recent economic data and anticipated inflationary pressures, notably from recently imposed tariffs. The May Consumer Price Index (CPI) indicated year-over-year inflation at 2.4%, an uptick from April's 2.3%, with a month-over-month increase of 0.1% which was below consensus expectations. This relatively benign CPI print, coupled with what Bank of America terms a "solid May jobs report"—despite the unemployment rate rising to 4.2% from 3.4% in 2023 and a reported 80% year-to-date increase in layoffs through May compared to the prior year—has led the bank's analysts to reduce the perceived risk of stagflation. Consequently, Bank of America sees a lower probability of 'bad' rate cuts prompted by a labor market collapse and an increased chance of 'good' cuts driven by a resilient labor market alongside decelerating inflation. Nevertheless, analysts anticipate the primary inflationary impact from significant tariffs (including 25% on Canadian, Mexican, and auto imports, approximately 55% on Chinese goods, and a 10% baseline import tariff) is largely "still in the pipeline" and will become more apparent in subsequent months. This expectation of rising inflation is projected to keep the Federal Reserve in a holding pattern throughout 2025, maintaining its policy rate as it navigates its dual mandate amidst tariff-induced price pressures and evolving labor market conditions.

Key Decisions for Investors

• Anticipate continued pressure on interest-rate sensitive sectors, such as housing, through 2025 due to Bank of America's forecast of the Federal Reserve maintaining current rates, with potential easing not expected until 2026.
• Closely monitor upcoming inflation data and its drivers, particularly the pass-through effects of tariffs, as Bank of America highlights this as a key factor influencing the Federal Reserve's policy stance and the timing of future rate adjustments.
• Evaluate labor market trends, including the 4.2% unemployment rate and the significant 80% year-to-date rise in layoffs, as further deterioration could accelerate Fed action, while the current 'solid' jobs report, according to BofA, supports the possibility of 'good' cuts later.
• Strategically consider the implications of a potential 1% Federal Reserve interest rate reduction forecasted by Bank of America for 2026 in long-term asset allocation, while navigating near-term market volatility linked to ongoing tariff-related inflation concerns and employment data.