Could the Fed Be Forced to Resume Hiking Rates?

By Alexander Jones, International Banker At the European Central Bank’s (ECB’s) annual forum on July 1, Kevin Warsh was asked whether the Federal Reserve (the Fed) might need to raise interest rates again. Although the Fed’s new chair declined to answer directly, he acknowledged that inflation is still too high and that the final decision would be made only after policymakers had reviewed the incoming data and debated the issue behind closed doors. Nonetheless, with growing hawkishness unfolding among market analysts, the probability of an imminent rate hike—or at least, one before year-end—is firmly on the rise. Just a few months ago, markets expected the Fed to resume its rate-cutting cycle, in recognition of prices continuing to ease gradually. With soaring energy prices stemming from the Persian Gulf conflict renewing a persistent inflationary environment, however, debate is now intensifying over whether the next move could be a rate increase amidst the highest annual price rises in three years. Although a rate hike before the end of the year is still not the most likely outcome, it is fast becoming a serious possibility. At its June 16-17 meeting, the Federal Open Market Committee (FOMC) left its benchmark federal funds target range unchanged at 3.50-3.75 percent. The rate-setting committee’s accompanying statement, meanwhile, acknowledged that the economy is still solidly expanding with strong productivity growth and capital investment, while job gains are keeping pace with the workforce with little change in unemployment. Relative to the Fed’s 2-percent goal, moreover, inflation remains elevated, partly due to supply shocks in sectors such as energy. Policymakers also raised their median June 2026 forecast for the Fed’s preferred inflation gauge, the Personal Consumption Expenditures (PCE) Price Index, to 3.6 percent, up from the 2.7 percent projected in March, while the median projection for core PCE inflation (excluding food and energy) rose to 3.3 percent from 2.7 percent. The median projection for the federal funds rate at the end of 2026 increased to 3.8 percent, compared with 3.4 percent three months earlier. Although telling, the numbers do not guarantee a rate hike. They do, however, show that the Fed’s internal expectation of inflation is moving markedly higher, accompanied by the appropriate policy-rate path. As such, the Fed’s own forecasts make a rate hike increasingly credible, even if it has not explicitly committed to doing so. What’s more, PCE and core PCE figures rose year-on-year by 4.1 percent (PCE’s highest level in three years) and by 3.4 percent, respectively, for May. The more serious problem for the Fed, therefore, is not merely that energy prices are rising in response to the Persian Gulf conflict, but that core inflation has also risen, suggesting that the price pressure is not solely attributable to volatile oil and gas prices. A temporary oil shock can be tolerated if inflation expectations remain stable and the pass-through to the broader economy is limited. For the Fed, identifying this distinction is critical. A temporary oil shock can be tolerated if inflation expectations remain stable and the pass-through to the broader economy is limited. But a rise in core inflation is tougher to ignore. At the same time, Warsh has been keen to reinforce the Fed’s core message, which could conceivably be interpreted as implying that monetary tightening is at the very least being considered. “We’ve all looked around, and we’ve seen that prices are too high, and I don’t think I’m the only one on this stage that’s recommitted to deliver price stability,” Warsh acknowledged at the ECB forum in Sintra, Portugal, which hosted the heads of several leading central banks. “We’re going to deliver price stability in the US. That’s what this committee has signed up to do.” This increased acknowledgement of rising inflationary pressures by policymakers perhaps explains why some analysts have sharply adjusted their assessments. Bank of America now expects three 25-basis-point hikes this year, arguing that the Fed’s inflation problem has become harder to dismiss and that tariff effects, energy shocks, sticky services inflation and the fading of housing-driven disinflation all reduce the case for patience. “The Fed’s inflation problem has gotten unambiguously worse,” wrote Bank of America economist Aditya Bhave in a June 22 note. “The Fed was willing to look through the tariffs, but it is losing patience after the latest round of supply shocks. Also, housing-driven disinflation has now mostly run its course, while other core services remain very sticky.” Deutsche Bank has also moved in favour of rate hikes, albeit less aggressively. Nonetheless, the increasingly hawkish forecasts reflect the views of a growing chorus of reputable analysts who believe that current rates are not restrictive enough. There are several possible reasons why the FOMC might lean in that restrictive direction. Some may worry that demand is stronger than expected, supported by AI-related capital spending, resilient household consumption and buoyant financial markets. Others may believe that policy has not been as effective at containing prices as assumed, such that a nudge higher might do the trick. The Fed has faced repeated inflationary shocks: tariffs, energy-price swings, geopolitical disruptions and earlier supply-chain pressures. Then there is the issue of credibility. The Fed has faced repeated inflationary shocks: tariffs, energy-price swings, geopolitical disruptions and earlier supply-chain pressures. Even if each individual shock can be described as temporary, the cumulative effect might keep inflation above target for long enough to threaten expectations. Compelling arguments against higher rates also persist. While acknowledging that the Fed has raised its core PCE forecasts, UBS contended that markets are overpricing near-term hikes and that the inflation backdrop is combined with “a stable labour market that was not presented as a primary driver of price pressures”. As such, the Fed does not see an immediate need to tighten policy in response to labour-market overheating, according to the Swiss bank. “Additionally, May’s consumer price index pointed to a re-emergence of core goods disinflation, with underlying details showing a clear deceleration in price increases in tariff-sensitive categories,” UBS’ chief investment office also wrote in its June 23 note. “This indicates that tariff pass-through, which had been a meaningful contributor to core inflation in recent quarters, is beginning to unwind, and it could reduce inflation trends by 0.8 percentage points over the next year.” Reuters polling tells a similar story. Most economists still expect the Fed to hold rates steady through the rest of 2026. “At the moment, holding rather than hiking is the most appropriate stance. The committee is effectively split right down the middle…there are a couple that would be swayed by this aggressive move in energy prices,” said Josh Hirt, senior US economist at Vanguard, who previously expected a cut. While the consensus has moved decisively away from cuts, it has not moved fully towards renewed tightening. This highlights a crucial distinction: Despite the renewed hawkishness, the actual threshold for enacting a rate hike has not yet been met. And while the probability of a rate hike has increased, the base case is still an extended hold. The AI-investment boom adds another layer of complexity. While artificial intelligence (AI) could be disinflationary in the long run if it raises productivity, reduces costs and allows firms to produce more with fewer resources, the ongoing capital spending spree on building data centres, power infrastructure, semiconductor capacity and cloud-computing networks is likely to have the opposite effect and contribute to inflationary pressure in the short term. The Fed cannot set policy solely on the basis of the productivity gains that may arrive in the 2030s. It must respond to demand conditions in 2026. While that does not automatically justify monetary tightening, it helps explain why policymakers might not be confident in the restrictive power of current rates. Even without another hike, markets have started to adjust to the possibility of one. Short-dated Treasury yields have moved higher as investors price in a Fed strategy that might stay restrictive for longer. The yield curve has also flattened, reflecting the risk that near-term rates will remain elevated even if longer-term growth expectations are more subdued. A less predictable Fed also increases the chance of higher rate volatility, as investors can no longer rely on detailed guidance to anchor expectations around each meeting. For the Fed to raise rates again before year-end, it would most likely need evidence that inflation persistence is becoming harder to explain away as temporary, especially with respect to core inflation rather than the headline measure. Conversely, the case for holding is also clear. If oil prices retreat, tariff pass-through fades, core inflation softens, and the labour market cools, the Fed can justify patience, arguing that tightening into supply shocks would create unnecessary downside risk. While the Warsh regime has not signalled that rates are unambiguously heading higher, we can at least assume with greater confidence that they will not be coming down any time soon.