Recently, heightened tensions in the Middle East have triggered significant market volatility, coupled with rising inflation expectations, leading Wall Street to bet that the Federal Reserve would abandon rate cuts this year or even shift to rate hikes. In response to this shift in sentiment, Federal Reserve officials have spoken out in succession, aiming to stabilize market expectations. On Friday, Fed Governor Christopher Waller and Vice Chair for Supervision Michael Barr respectively stated that they still anticipate rate cuts in the future, suggesting that the market’s hawkish bets may be overly aggressive. Notably, another Governor, Adriana Kugler, also leans toward easing and dissented from keeping interest rates unchanged at this week’s policy meeting, advocating for an immediate 25 basis point cut.
Although market expectations have reversed sharply in just three weeks, the Fed’s official policy path has not fundamentally shifted. The updated interest rate dot plot released this week shows that 19 policymakers overall still anticipate one rate cut this year. Barr stated in an interview that, considering the weakening labor market, he expects three rate cuts by the end of 2026. Waller was relatively more cautious but still left room for rate cuts. He noted that if the labor market continues to weaken, he would once again support a rate cut this year.
The recent “hawkish turn” in market sentiment partly stems from Fed Chair Jerome Powell’s remarks at the press conference. At that time, he emphasized the inflation risks posed by the Middle East conflict, made limited mention of the deteriorating employment market, and repeatedly highlighted the uncertainty of the future path, leading markets to interpret the stance as potentially tightening. However, employment data is sending different signals. U.S. employment fell by 92,000 in February, and if this trend continues, the labor market will noticeably weaken. Some institutions expect that the seasonal pattern of employment weakness in spring and summer may reoccur, pushing up the unemployment rate and ultimately forcing the Fed to cut rates.
In contrast, achieving a rate hike path would require meeting multiple conditions, including the unemployment rate remaining below 4.5% and core inflation rising above 3.2% on an annual basis. This scenario is more likely to occur in an environment of modest and sustained oil price increases, but the probability of such an outcome is currently limited. Waller stated that while rising oil prices could intensify inflationary pressures, the possibility of rate cuts this year remains if the labor market continues to weaken. He emphasized the need for caution but noted that this does not mean no action will be taken throughout the year. As a key intermediate input, the transmission effect of rising energy prices will permeate a broader range of goods and service prices. With the conflict persisting, the risk of oil prices remaining elevated rises, and inflationary pressures may become more persistent.
Divisions remain within the Fed regarding the future policy path. Waller revealed that, were it not for the new risks arising from the Iranian conflict, he would have been inclined to dissent again from the decision to “hold steady,” indicating that geopolitical factors have begun to significantly influence policy judgments. The latest economic forecasts also reflect diminished confidence in the decline of inflation, with Fed officials raising their 2026 inflation projection from 2.4% to 2.7%. Meanwhile, labor market uncertainties are also increasing, and the policy statement has removed the phrase describing the job market as “stabilizing.” Earlier that day, Barr also stated that he still expects three 25 basis point rate cuts in 2026, while acknowledging that the impact of the Iranian conflict remains difficult to assess.
