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In just the past few weeks, the Federal Reserve’s policy narrative has undergone a sharp reversal — shifting from rate cut expectations to rate hike concerns, with markets reacting strongly.
On May 12, the U.S. Bureau of Labor Statistics released data that poured cold water on markets: the April CPI rose 3.8% year-on-year, the largest increase since May 2023, far exceeding the previous reading of 3.3% and expectations of 3.7%. More troubling, core CPI, which excludes food and energy, climbed to 2.8% year-on-year, also beating expectations. Soaring energy prices were the main driver of this inflation rebound — energy commodity inflation surged 29.2% year-on-year in April, with gasoline prices up 28.4% and fuel oil soaring 54.3%.
The core variable pushing up energy costs stems from the Middle East. The ongoing closure of the Strait of Hormuz poses a substantive threat to global energy supply, with international oil prices easily breaking through the $100 per barrel mark, directly feeding into the U.S. Consumer Price Index. This geopolitical shock has pushed U.S. inflation back into a range not seen since 2023, making the Fed’s path to its 2% inflation target even longer.
Market Pricing Reverses: Probability of a Rate Hike Jumps to 60%
The capital market reaction has been most direct. According to the CME Group’s FedWatch tool, as of May 19, traders are pricing in a greater than 50% probability of a rate hike in December, with the probability for January rising to 58%. As recently as March, the median of FOMC members’ rate projections still hinted at a possible rate cut by year-end. In just two months, market expectations have nearly performed a U-turn.
In the bond market, rising long-end yields are also sending warning signals. The 30-year Treasury yield briefly broke above 5%, while the 10-year yield remained high at 4.4%, with the bond market putting pressure on the Fed in a market-driven way.
Labor Market: Mixed Signals Amid Resilience
A key pillar supporting the Fed’s wait-and-see stance — the labor market — is not as strong as it appears on the surface. April nonfarm payrolls added 115,000 jobs, beating expectations of 62,000 but showing a notable slowdown from March’s revised figure of 185,000. More deeply, the labor force participation rate fell to 61.8%, the lowest since October 2021, as more workers left the labor force. Meanwhile, the U-6 broad unemployment rate rose from 8.0% to 8.2%, reflecting deteriorating job quality. As Philadelphia Fed President Harker noted, the “unusual stability” of the unemployment rate masks structural concerns in the labor market to some extent. This pattern of “calm on the surface, divergence underneath” adds complexity to the Fed’s policy trade-offs.
Divided Leadership, New Chair’s Stance Unclear
The April FOMC meeting saw a rare 8 4 vote to keep rates unchanged, the highest number of dissents since 1992, exposing deep rifts within the decision-making body. Moreover, several Fed officials have recently released hawkish signals. Chicago Fed President Austan Goolsbee made clear: “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.” Boston Fed President Susan Collins also publicly raised the possibility of a rate hike, even stating that she “can envision a scenario that requires some policy tightening to ensure that inflation returns durably to 2%.”
Incoming Fed Chair Kevin Warsh will be sworn in this Friday, and his policy leanings remain uncertain. President Trump has said he expects Warsh to cut rates, but Warsh emphasized the independence of the Fed’s rate decisions during his Senate confirmation hearing. Given the reality of unexpectedly high inflation, Warsh’s top priority upon taking office will be to quickly establish anti-inflation policy credibility — meaning he is unlikely to send dovish signals at the June meeting. Wall Street strategist Ed Yardeni has warned that “bond vigilantes” are forcing the Fed to turn hawkish by selling Treasuries, and Warsh may even raise rates as early as July.
Outlook: Balancing Price Stability and Growth Tests Policy Wisdom
The Fed currently finds itself in a dilemma: if it insists on raising rates to curb inflation, the already weak job market could come under further pressure; if it stands pat or even cuts rates, it risks de-anchoring inflation expectations. The latest Reuters survey shows that most economists expect the federal funds rate to remain unchanged at 3.50%-3.75% at least through the third quarter, with the inflation outlook revised up to 3.9% in the second quarter.
When the Strait of Hormuz will reopen has become the most uncertain external variable for the U.S. inflation outlook. If the conflict persists, inflation stickiness could far exceed expectations, and the Fed may be forced to restart rate hikes in the second half of 2026 — marking the most dramatic policy reversal since the end of the 2023 rate hike cycle.
