Political interference, room for interest rate cuts, controversy over balance sheet reduction...six difficulties that the Fed cannot avoid in 2026

# Written by: Li Jia

# Source: Wall Street Insights

The Federal Reserve faces a slew of critical challenges in 2026, spanning from policy independence to the reform of its monetary policy framework. These issues will exert a profound impact on the trajectory of global financial markets and shape investor expectations.

Market attention on the next Fed Chair has been mounting, yet this is just one of the many hurdles the central bank must overcome this year. Six key topics—political interference, room for interest rate adjustments, balance sheet reform, stablecoin regulation, and the monetary policy framework—will test the decision-making prowess of the world’s most influential central bank.

These issues carry systemic implications. If political pressures erode market confidence in the Fed’s commitment to taming inflation, it could trigger severe unanchoring of expectations and heightened volatility. Meanwhile, the Fed’s choices on technical matters such as interest rate policy and balance sheet management will directly influence market fluctuations and financial stability.

Fed Chair Jerome Powell previously stated that after three 25-basis-point rate cuts last year, monetary policy now stands "within the reasonable estimated range of the neutral interest rate". However, how the incoming Chair maintains decision-making independence amid political pressures and advances consistent policy and regulatory reforms amid multiple challenges will be the core narrative to watch throughout the year.

## Political Independence Under Scrutiny

Donald Trump’s attempts to influence interest rate trends pose a tangible threat to the Fed’s independence. Even if the next Fed Chair is inclined to further cut rates to align with Trump’s preferences, this policy path is far from certain. The Chair must secure the support of the Federal Open Market Committee (FOMC); otherwise, the Fed risks damaging its credibility and failing to communicate effectively with the market. In fact, striking a balance among FOMC members, the Fed’s professional staff, financial markets, and the President will be an arduous test of leadership.

At the same time, the unresolved case of Trump’s bid to dismiss Fed Governor Lisa Cook on "just cause" grounds remains pivotal. Should the Supreme Court ultimately expand the President’s authority to remove Fed officials—including FOMC members—it will significantly strengthen the executive branch’s ability to interfere in monetary policy decisions. It may also allow Trump to reshape the Committee’s composition, thereby undermining the long-standing foundation of the Fed’s policy independence.

## Interest Rate Policy Enters a Wait-and-See Phase

From an economic fundamentals perspective, the Fed has ample justification to keep policy stable. The dilemma between a resilient labor market and inflation gradually returning to the 2% target is expected to ease over time. It will take a considerable period to accumulate sufficient evidence to justify further adjustments to interest rates.

Current economic growth drivers exhibit sustainable characteristics, underpinned by expanding AI investments, the implementation of tax cuts, and broadly accommodative financial conditions. Inflationary pressures stemming from tariffs are projected to subside around the middle of the year; moreover, thanks to exemption clauses and trade renegotiations, their actual impact may be milder than expected. Additionally, housing inflation has shown signs of cooling, partly due to immigration policy tightening that has curbed household formation, easing upward pressure on shelter costs.

## Balance Sheet Reform in the Spotlight

The Fed is planning to continue purchasing Treasury securities to maintain a sufficiently sized balance sheet, ensuring the banking system has ample cash reserves and safeguarding the smooth operation of short-term lending markets. However, some candidates for the Fed Chair position have proposed drastically shrinking the balance sheet. If this proposition is put into practice, it could complicate the implementation of monetary policy, exacerbate interest rate volatility, and heighten contagion risks within the banking system.

Currently, the size of the Fed’s balance sheet stands at $6.6 trillion. How to effectively manage this massive asset portfolio will exert a crucial impact on liquidity conditions and overall stability in financial markets.

## Bank Regulation in Urgent Need of Overhaul

The regional banking crisis of 2023 exposed significant flaws in financial regulation, both in terms of processes and culture. Fed Vice Chair Michelle Bowman noted that regulation should focus on core issues related to banking safety and soundness, advocating for the simplification of overly complex and redundant rules in the existing system.

While this direction is reasonable, its effective translation into practice remains to be seen. It is crucial to guard against the risk that regulatory adjustments may only be superficial relaxations, which could expose taxpayers and the broader economy to unnecessary risks.

## New Approaches to Stablecoin Regulation

Fed Governor Christopher Waller recently proposed opening a type of "streamlined accounts" to fintech firms holding limited banking licenses. For instance, stablecoin issuers could be allowed to deposit their reserves at the Fed, thereby enhancing the transparency and security of their funds.

However, such accounts differ significantly from traditional Fed accounts: they neither earn interest nor offer intraday overdrafts or access to the Fed’s discount window lending. These restrictions may be acceptable during periods of market stability but would severely diminish their practical utility amid financial stress, potentially even triggering liquidity risks.

How to design and refine the supporting mechanisms for these new types of accounts is not only critical to the operational viability of fintech companies but will also profoundly shape the future structure and stability of the U.S. payment system.

## The Need to Reform the Monetary Policy Framework

The Fed’s current communication strategy—particularly its quarterly Summary of Economic Projections—centers on modal forecasts, which to a certain extent obscures the more complex considerations underpinning policy decisions. For example, the report fails to clearly distinguish whether disagreements over the future interest rate path stem from policymakers’ divergent assessments of the economic outlook or from differing views on the appropriate monetary policy responses to the same economic conditions.

To enhance transparency and policy effectiveness, the Fed may consider structural reforms, such as publishing staff economic forecasts that include alternative scenarios, similar to the approach adopted by the European Central Bank. This "scenario-based" communication can help the market better understand how the Fed might adjust its policies if economic conditions deviate from the current baseline forecast. This will not only help stabilize market expectations but also make monetary policy transmission more effective.

Although Fed Chair Jerome Powell hinted at considering reforms to the communication approach last May, substantive progress has yet to materialize. Whether the next Chair will prioritize and advance this reform will be a key policy focus worthy of close attention in the future.

## Disclaimer

The market is risky, and investment requires caution. This document does not constitute investment advice. Users should consider whether any opinions, views, or conclusions contained herein are in line with their specific circumstances. Investment decisions made based on this document shall be at the user’s own risk.