It appears that nearly everyone is nervous about the stock market heading into 2026, and for good reason.
By many measures, the S&P 500 Index (^GSPC 1.11%) is expensive and dominated by just a handful of stocks. Along with higher-than-average stock valuations, the setup for 2026 has some eerily similar characteristics to recent bear markets, specifically those of 2018 and 2022.
Like those years, 2026 will be a midterm election year, when the honeymoon period for the new presidential term fades. In addition, both of those years' market sell-offs were caused by a rise in inflation and interest rates. In fact, each of the past two severe bear markets outside of the COVID-19 crisis was caused by inflationary pressures and higher rates to combat them.
While inflation has seemingly stabilized and interest rates are currently coming down, there's a very plausible 2026 scenario for yet another inflation problem to emerge.
Image source: Getty Images.
Jerome Powell's term is up in May
Current Federal Reserve Chairman Jerome Powell's term ends in May of 2026, which could be a big issue for the markets next year.
Powell has been Chair since 2018. While some have criticized individual decisions the Fed made over a very turbulent period, in general, Powell has been a source of stability. Over his term, Powell has been a fiercely independent Federal Reserve Chair, despite periods of political pressure, the unprecedented COVID-19 pandemic, as well as the post-pandemic inflationary spike. Respected by both sides of the political aisle, he was nominated to the chairmanship during President Trump's first term, then renominated by President Biden in 2022.
Yet while Powell was initially nominated to the Chairmanship by President Trump, President Trump has been highly critical of the Fed Chair during both of his terms, especially whenever Powell has deemed it necessary to raise interest rates.
In 2018, inflation began to rise, and the Fed started raising interest rates. The subsequent market downturn irked President Trump, who seemed to blame the 2018 stock market decline on the Fed raising the Federal Funds rate in order to tamp down inflationary pressures. In late 2018, just one year after Powell's nomination, he said, "I'm not even a little bit happy with my selection of Jay."
Of course, the 2018 interest rate hikes paled in comparison with the 2022 post-pandemic inflation, which was followed by the fastest increase in interest rates in history and another severe bear market. After the interest rate increases over 2022 and 2023, inflation began to fall, and the Federal Reserve has prudently followed by cutting interest rates since the middle of 2024. As a result, the markets have recovered well since 2022's severe downturn.
Target Federal Funds Rate Upper Limit data by YCharts
However, President Trump has maintained his critical stance of Powell. In a case of history repeating itself, President Trump has called on Powell to lower rates more aggressively during his second term, especially after President Trump's tariff policies initially roiled markets earlier this year. Even when the Federal Reserve lowered the Federal Funds rate by a quarter point last week, to 3.75%, it wasn't good enough for President Trump, who said the cuts should have been, "at least doubled."
Why it's important that the Fed Chair is independent
If the new Fed Chair takes their cues from the President's political considerations rather than an independent assessment of the economy, it could be highly damaging.
There are historical examples of this danger -- no, President Trump is certainly not the first President to exert pressure on the Federal Reserve to keep interest rates low.
In both the Lyndon Johnson and Richard Nixon Administrations, Presidents Johnson and Nixon each pressured their Federal Reserve Chairman to keep interest rates low for the sake of job creation and their own political considerations, despite rising inflation.
While there is never one exact cause for a broad, economy-wide hyperinflation, many economic historians attribute the higher and persistent inflation of the late 1960s and mid-1970s to these overly stimulative policies, at least in part.
The high and persistent inflation throughout the 1970s brought on one of the most severe and prolonged bear markets in history. Thus, when inflation rises, it's of utmost importance for the Fed to slow the economy to tamp down inflation before it gets out of control, thereby requiring more severe measures later on.
Who will Trump appoint? And will they be independent?
With Powell's term ending soon, Trump will soon make a new nomination. When asked about the characteristics he would look for in a new Fed Chair, President Trump has said, "I'm looking for somebody that will be honest with interest rates ... Our rate should be much lower."
Two candidates have been circulating in the media. The first is Kevin Warsh, a former Federal Reserve Governor, and the second is Kevin Hassett, Trump's current National Economic Council Director.
Wall Street appears to be more anxious over Hassett if he is the choice, given that he currently works inside the Administration and has regularly appeared as a pundit on television on the Administration's behalf. Therefore, it's not outrageous to think Hassett could potentially be "less than independent" with regard to monetary policy if confirmed as Fed Chair.
For Hassett's part, when asked if the President would hold sway over any Federal Reserve board decisions if he were Chair, Hassett said no, albeit with some caveats:
No, he would have no weight... His opinion matters if it's good, if it's based on data... And then if you go to the committee and you say, well, the president made this argument and that's a really sound argument, I think, what do you think? If they reject it, then they'll vote in a different way.
What to watch for in 2026
Once Trump's appointment is made, investors should pay close attention to the new Fed Chair's interviews and press conferences. Perhaps more importantly, investors should closely monitor what the Fed actually does in response to incoming economic and inflation data.
If inflation persists above the Fed's 2% target and the new Fed Chair's Open Market Committee keeps rates low or even cuts them, it could signal a potential inflation problem ahead.
As the U.S. economy experienced in both the 1970s and in the brief post-pandemic inflationary period, markets tend not to do well in a higher-inflation environment.
