Hassett is set to become the chairman; will the Fed be "dovish to the extreme" next year? But can inflation hold up?

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For the market, regardless of who the next Federal Reserve Chair will be, the institution’s credibility in fighting inflation remains an unshakable bottom line. Although the market is currently immersed in expectations of a dovish monetary policy, the prospects of strong growth and stubborn inflation in 2026 are posing a serious challenge to this dovish narrative.

Recent market volatility highlights investors’ sensitivity to monetary policy. Last month, hawkish comments by Fed Chair Powell following the FOMC meeting caused the Nasdaq 100 Index to drop about 8% from its highs. However, the dovish speech by New York Fed President John Williams on November 21 quickly reversed market sentiment, not only leading the stock market to almost fully recover its losses, but also pushing the probability of a December rate cut up to 85%.

At the same time, discussions over the next Fed Chair have also become a market hot topic. On Tuesday, according to “the new Federal Reserve press office,” WSJ reporter Nick Timiraos reported that President Trump seems to favor longtime advisor Kevin Hassett for the role. According to Polymarket data, his nomination probability has risen to 80%. Hassett is widely viewed by the market as a proponent of dovish monetary policy, further reinforcing dovish expectations.

Despite current concerns regarding the health of the U.S. labor market providing a reasonable basis for short-term easing measures such as rate cuts, this short-term consensus masks the upcoming long-term challenges. If macroeconomic data for 2026 shows a resurgence of inflationary pressures, then regardless of who leads the Fed, both their ability to maintain accommodative policy and institutional credibility will face strict market scrutiny. Should inflation expectations become unanchored, it could lead to higher U.S. long-term interest rates and currency depreciation.

Dovish Expectations Heat Up, Market Calm in the Short Term

Currently, financial markets appear to be fully prepared for a dovish new Fed Chair. Investors widely expect that after Powell’s term ends, the Fed will introduce further rate cuts, with the terminal rate priced at around 3%, reflecting a strongly dovish policy outcome.

Under these expectations, market performance has been stable: the USD exchange rate is steady, the yield curve fluctuates within a range, the 30-year U.S. Treasury yield remains below 5%, and the 10-year breakeven inflation rate is at the lower end of the 2.25% range.

According to Citi analyst Nohshad Shah, current rate-cutting discussions are not unfounded, as genuine concerns over a weakening labor market provide credible reasons for policy shifts. This means that regardless of the next Chair’s personal policy preferences or reputation, the short-term policy direction—favoring easing—appears to be set.

Dual Challenges of Growth and Inflation: Bleak Macro Outlook for 2026

However, looking toward 2026, macroeconomic prospects may force monetary policymakers to rethink their dovish stance. Analysis suggests that active fiscal stimulus and persistently loose financial conditions may provide significant additional momentum for economic growth in 2026.

Based on the Fed’s Financial Conditions Index (FCI-G) and fiscal impulse measurements, these two factors are expected to boost 2026 economic growth by about 100 basis points. Considering the post-immigration policy tightening long-term trend growth rate in the U.S. is about 1.75%, this means that actual GDP growth in 2026 could reach roughly 2.75%. This forecast is far higher than the National Association for Business Economics (NABE) median expectation of 2% from 42 professional forecasters.

While growth prospects are strong, inflation remains troublesome. Currently, core inflation remains about 1 percentage point above the Fed’s 2% target, and its downward momentum has stalled. With a positive output gap of 100 basis points, it is hard for analysts to see deflationary forces emerging next year. Nohshad Shah expects inflation may stagnate at 3.0% or even higher. If this scenario comes true, the U.S. nominal GDP growth rate would reach 5.75%, creating a typical “re-inflation” environment.

Central Bank Credibility Faces Key Test, Market May Be the "Policy Brake"

In a re-inflation environment, any central bank sticking to a dovish stance will face a crucial test of its credibility. If the Fed continues to cut rates even as both growth and inflation climb, pushing rates below 3%, the market may seek its own equilibrium and play the role of “policy brake.”

Historical experience shows that when central bank credibility is damaged, more drastic “overcorrection” is needed to bring inflation back to target. This often leads to a more severe economic recession than anticipated and ultimately results in long-term negative impacts on the stock market. Therefore, if the market believes Fed policy is losing credibility, it may actively tighten financial conditions by selling bonds and stocks—for instance, driving up the 10-year Treasury yield and depressing the stock market.

While in the short term, the market may interpret “pro-cyclical” easing as good for corporate earnings, this will only mean that interest rates eventually need a larger increase to offset that effect. Once the 10-year Treasury yield approaches the 4.5%-5% level, it will quickly become a drag on the stock market.

Outlook for Asset Prices Balanced, but Volatility Likely to Intensify

Overall, the outlook for asset prices is balanced. Positive growth prospects along with accommodative monetary and fiscal policy provide support for the stock market. On the other hand, uncertainty around how monetary policy will respond, and excessive valuations in some AI sector companies, suggest that recent market volatility will persist.

Especially in the AI sector, the stage of “a rising tide lifts all boats” has ended and investors are becoming more discerning, beginning to scrutinize the scale of some companies’ debt issuance. Meanwhile, competition within the industry is intensifying: for example, the contest between Google and Nvidia over chip dominance is rapidly narrowing valuation gaps, requiring investors to spot winners and losers.

Looking ahead, risks are building in the market, mainly including: synchronized rises in growth and inflation under a re-inflation environment, sharp labor market deterioration triggering recession, and a dramatic reversal of AI optimism. This means the market needs to price in a wider range of outcomes, and potential volatility is expected to rise.

Risk Warning and DisclaimerThe market involves risk, and investment must be cautious. This article does not constitute personal investment advice, nor does it consider the specific investment goals, financial situation, or needs of individual users. Users should consider whether any opinions, viewpoints, or conclusions in this article apply to their own circumstances. Any investment decisions made on the basis of this article are at the user’s own risk. ```