Why the Fed May Be Convinced to Reverse Course on Interest Rates

Key Takeaways

• Financial markets are now pricing in a greater than 50% chance of a rate hike this year.

• The ongoing closure of the Strait of Hormuz has pushed up fuel prices, stoking inflation and raising concerns among Fed officials that price increases are accelerating too quickly.

• More Fed officials have shown an inclination to pump the brakes on the economy by raising its key interest rate, which pushes up borrowing costs across all kinds of loans.

It’s looking more and more likely the Federal Reserve will be forced to raise interest rates to deal with rising inflation, according to investors.

Last week, financial markets were pricing in about a 60% chance that the Federal Reserve would keep its key interest rate unchanged through its December meeting, according to the CME Group’s FedWatch tool, which forecasts rate movements based on fed funds trading data.

On Tuesday, those odds changed as intensifying concerns about inflation pushed up yields on Treasury bonds. Traders are now pricing in a 58% chance of a rate hike in December and a 40% chance the central bank will not change its influential interest rate.

Should the Fed’s policy committee decide to raise the fed funds rate from its current level of 3.5% to 3.75%, it would be the first hike since 2023, when the Fed completed its campaign of rate hikes to deal with the post-pandemic surge of inflation.

What This Means For the Economy

Higher interest rates could help push down inflation, but might damage a job market already plagued by low hiring rates.

That would also be a sharp reversal from just a few months ago, when the Fed was moving in the opposite direction. The central bank’s policy committee cut its rate by a quarter-point at each of the last three meetings last year to boost the ailing job market.

The Iran war has shaken up the economic outlook by driving prices for crude oil, gasoline, and other commodities. Fed officials have become increasingly worried that the spike in gas prices could fuel more persistent inflation, especially if the crucial Strait of Hormuz is not reopened soon. In recent speeches, more Fed officials have raised the possibility of rate hikes.

“I’m more concerned about the inflation side,” Austan Goolsbee, president of the Federal Reserve Bank of Chicago, said in an interview last week. “If it starts going off the rails, then I think the Fed has got to consider options like even higher rates to try to stop the inflation.”

The fed funds rate is the Fed’s main monetary policy tool for fulfilling its dual mandate to keep inflation low and employment high. The central bank typically raises rates, which pushes up borrowing costs on all kinds of loans, when it wants to discourage spending and stifle inflation. It does the opposite when the job market is the main concern, and pushes down borrowing costs to encourage spending and hiring.

And while the Fed does face pressures on both sides of that mandate, inflation has taken a sharper turn in the wrong direction. Higher gas prices helped push the Consumer Price Index to a three-year high annual increase in April, and inflation measures haven’t touched the Fed’s goal of a 2% annual rate since 2021.

Susan Collins, president of the Boston Fed, also brought up the possibility of a rate hike last week in a speech to the Boston Economic Club.

“While I hope policy normalization can resume late this year, I can also envision a scenario that requires some policy tightening to ensure that inflation returns durably to 2%,” she said, according to prepared remarks.

Jeffrey Schmid, president of the Kansas City Fed, called inflation “the most pressing risk to the economy,” when speaking at a conference in Missouri last week.

Neel Kashkari, president of the Minneapolis Fed, also raised similar concerns at a Q&A in St. Paul, Minnesota, last week.

“Now there’s just a huge question mark of how long the Strait of Hormuz is going to be closed, because that is going to have a big effect on what is the path forward for inflation,” he said. “We just don’t know right now.”

Not every Fed official has sounded so inclined towards rate hikes. Earlier in the month, John C. Williams, president of the New York Fed, stressed a balanced approach in a speech at a symposium in New York. However, that speech was delivered before the April CPI report was published, which raised red flags about consumer prices.

A major open question for the Fed’s policy is how incoming Fed Chair Kevin Warsh will react to those pressures.

President Donald Trump has said he expects Warsh to cut rates, but it’s unclear whether Warsh agrees or whether he would be able to convince a majority of the 12-member Federal Open Market Committee to go along with cuts.

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