The risk of stagflation increases decision-making difficulty as Fed rate hike expectations rise.

Source: China News Service

Currently, the Federal Reserve’s monetary policy outlook is experiencing subtle yet profound shifts—expectations for rate cuts are waning, and the possibility of rate hikes is coming back into view.

The core reason behind this reversal is the ongoing escalation of geopolitical conflicts in the Middle East, which increases inflationary risks. At the same time, with rising inflation pressures and a weakening U.S. labor market, the risk of stagflation in the U.S. economy is also increasing.

For the Federal Reserve, which has a dual mandate to promote maximum employment and maintain price stability, this directly complicates policy decisions. Interviewees believe that in the short term, the Fed is more inclined to stay on the sidelines. While discussions about rate hikes have heated up, the likelihood remains low. Looking ahead, geopolitical conflicts and stagflation risks will continue to be key variables influencing global asset trends.

Rate hike discussions intensify

The once-forgotten nightmare of rate hikes is once again casting a shadow over global financial markets.

Recently, due to escalating conflicts in the Middle East, market expectations for the Fed’s monetary policy have changed significantly. Although the latest dot plot from the Fed still indicates one rate cut this year, the interest rate market has begun pricing in the possibility of rate hikes. On March 23, the swap market showed expectations that the Fed would raise rates by 20 basis points this year.

The yield on the 2-year U.S. Treasury note, which is highly sensitive to policy rates, surged sharply. On March 24, Wind data showed that the 2-year yield reached a high of 3.912% intraday. Recently, the 2-year yield even broke above 4%, exceeding the upper limit of the Fed’s current federal funds rate target range by 25 basis points.

Moreover, discussions within the Fed about rate hikes are increasing. On March 23, Chicago Fed President Austan Goolsbee said in an interview that, given the impact of oil prices on the U.S. economy, the Fed may need to tighten monetary policy.

Recently, Fed Chair Jerome Powell also stated that he would not consider cutting rates until there is further improvement in inflation. He also mentioned that the Fed has begun internal discussions about the possibility of raising rates next, although this is not the baseline scenario for most officials.

Controlling inflation remains a top priority

The main driver behind the rising expectations for rate hikes is the renewed inflationary pressure caused by ongoing geopolitical conflicts.

Since the conflict in the Middle East escalated, shipping through the Strait of Hormuz has been disrupted, and international oil prices have surged significantly. Markets worry that high energy prices could push up overall U.S. prices, constraining room for rate cuts and possibly forcing the Fed to resume rate hikes to respond.

“The key is to see when the Strait of Hormuz will return to calm,” said Hu Jie, a former senior economist at the Federal Reserve and professor at Shanghai Jiao Tong University’s Shanghai Advanced Institute of Finance. “If shipping through the Strait of Hormuz can be significantly eased in the coming weeks, energy prices are likely to fall quickly, and the monetary policy paths of various central banks could return to their previous trajectories. Conversely, the policy path could be completely altered.”

The risk of “stagnation” in the U.S. economy is also accumulating. Goldman Sachs warned that rising oil and natural gas costs, tightening financial conditions, and weakening fiscal support are increasing the downside risks to U.S. economic growth, and the likelihood of recession is rising. Goldman currently estimates a 30% chance of recession within the next 12 months.

Amid the risks of both “stagnation” and “inflation,” the Fed faces a classic policy dilemma. Overall, the probability of rate hikes in the near term remains low. “For the current Fed, inflation clearly takes precedence,” Hu Jie said. “In the short term, the Fed is more likely to stay on the sidelines.”

Dong Zhongyun, Chief Economist at AVIC Securities, analyzed that triggering a rate hike by the Fed would require several conditions to be met simultaneously: first, core PCE inflation remains above the target and shows demand-driven characteristics; long-term inflation expectations significantly break out of the anchored range; wage growth and prices spiral upward; second, the unemployment rate stays below the natural rate with accelerating wage growth, maintaining high labor market tightness; third, real GDP growth remains above potential, indicating clear signs of overheating.

“Overall, the current situation is still distant from these conditions. Therefore, the Fed prefers to maintain the current restrictive interest rate level, using higher and longer rates to suppress inflation expectations. Rate hikes are a low-probability tail scenario, only likely if geopolitical conflicts escalate significantly, causing energy prices to soar and inflation expectations to become unanchored,” Dong Zhongyun said.