Philadelphia Federal Reserve President Anna Paulson, a 2026 voter on the Federal Open Market Committee (FOMC), indicated a preference to keep interest rates steady, stating that rate cuts would only be appropriate if there is continued progress in combating inflation.
Paulson stated on Tuesday that current monetary policy is "mildly restrictive," which is helping to curb inflationary pressures while the labor market remains stable. "Holding rates steady allows us to assess how the economy is evolving and the risks to price stability and the labor market," she said.
She noted that the unemployment rate has been "remarkably stable," indicating the labor market is "essentially in balance," while inflation was already too high even before the Middle East conflict pushed up energy prices. She added, "Assuming the labor market remains in balance, rate cuts would only become appropriate after we see sustained progress on inflation."
In recent days, global bond yields have surged as markets reacted to persistently high energy prices and increased bets on the possibility of further Fed rate hikes. Paulson commented, "I think it's healthy that market participants are beginning to accept a scenario where the federal funds rate could remain unchanged for an extended period, or even that further policy tightening may be necessary."
Paulson said she expects the labor market to remain stable and price pressures to "gradually recede" back to the 2% target. However, she also pointed out that the risks to achieving the inflation target "have increased." She emphasized that the future path will largely depend on how long disruptions to oil and other commodity supplies from the conflict persist.
"If the Middle East conflict is resolved quickly, with shipping and oil production returning to normal rapidly, then inflation and inflation risks are also likely to subside relatively quickly," she stated. "But if the conflict takes longer to resolve, then inflation, inflation risks, and risks to the labor market could remain elevated for a longer period."
Paulson also mentioned that households are facing pressure from high energy prices, with many consumers frequently switching from premium to cheaper brands, and some households increasingly relying on credit cards to maintain spending levels. However, she noted that despite these pressures, overall consumption has shown resilience. "While many households are feeling increased pressure from inflation, broadly speaking, there are few signs that consumers are cutting back significantly on spending," she said.
Paulson is the latest Fed official to strike a hawkish tone. Several other officials have recently signaled a more hawkish stance. Kansas City Fed President Schmid stated last Thursday that inflation is the biggest risk to the U.S. economy. Minneapolis Fed President Kashkari said last Wednesday that the Middle East war has exacerbated already high inflation, and the Fed must bring inflation back to its 2% target. Boston Fed President Collins also warned that if inflationary pressures do not ease, the Fed may need to raise rates again. Chicago Fed President Goolsbee pointed out last Tuesday that inflation is moving in the wrong direction, and this is not just related to oil or tariffs.
The emphasis on inflation from these officials points to a view that the Fed is "keeping the door open" for potential rate hikes.
**Renewed Inflation Concerns Fuel Fed Rate Hike Expectations**
Recent data confirms the inflationary pressures facing the U.S. economy. Driven by the Middle East conflict pushing up gasoline prices and a jump in grocery costs, U.S. inflation accelerated again, with the Consumer Price Index (CPI) rising 3.8% year-over-year in April, the fastest pace since 2023. Meanwhile, the Producer Price Index (PPI) surged 1.4% month-over-month in April, the largest monthly increase since March 2022, far exceeding the market expectation of 0.5%. The year-over-year increase reached 6.0%, the highest since December 2022, significantly above the 4.8% market forecast.
The dramatic shift in oil prices and the inflation environment has forced a historic reversal in market pricing for the Fed's policy path. Just before the Middle East conflict escalated in February, overnight index swaps indicated traders generally expected about 50 basis points of rate cuts from the Fed throughout 2026. However, the energy shock from the war has completely altered the interest rate outlook. Swap contracts now price in about 20 basis points of hikes by year-end, equivalent to an approximately 80% chance of a 25-basis-point hike. The market has fully priced in a 25-basis-point hike by January 2027, earlier than previously anticipated.
This shift in Fed policy expectations was already evident in internal Fed divisions. Last month's FOMC meeting saw the highest level of dissent since 1992, with as many as three officials voting against the policy statement's dovish-leaning language. Even previously dovish Fed Governor Milan has significantly softened his stance, substantially lowering his rate cut expectations. The stance of the incoming new Fed Chair, Walsh, has also drawn widespread market attention, with many expecting he will face extremely difficult policy choices upon taking office.
Several major Wall Street banks have also recently pushed back their forecasts for Fed rate cuts. These banks argue that both jobs and inflation data support the case for the Fed keeping rates unchanged at least until the end of this year. For instance, Aditya Bhave, Head of U.S. Economic Research at Bank of America, wrote in a report last week: "The data simply do not support a rate cut this year. Core inflation is too high and trending higher. The strong April jobs report was the last straw, especially given the hawkish comments from Fed officials." Bhave and his colleagues now expect the Fed will not cut rates again until July 2027, a significant shift from their previous forecast of a September cut this year.
The current consensus summary suggests the Fed has entered a "defensive mode." Rates will remain in the 3.50%-3.75% range or higher until the path for inflation to return to 2% becomes clear. Statements following the April rate decision indicate that internal Fed divisions between "fighting inflation" and "supporting growth" have reached their most severe level in years. The June policy meeting will be a key window to observe the policy style of the new Fed Chair, but given stubborn inflation and geopolitical risks, policy is likely to remain on hold in the near term.
The minutes from the Fed's April meeting will be released at 2:00 AM Beijing Time on Thursday (May 21). With signs of intensifying inflation pressures making rate hikes, rather than cuts, increasingly likely, these minutes are highly anticipated. Market investors hope to find clues about the possibility of Fed rate cuts or even hikes against the backdrop of high energy prices.
**Foresight or Overreaction? Bond Market 'Pre-Hikes' for Walsh**
The U.S. Senate voted last Wednesday to confirm Kevin Walsh's nomination as Fed Chair, paving the way for him to lead the central bank. Walsh has previously stated plans for "structural reforms" at the Fed, including enhanced coordination with the Treasury and the Trump administration on non-monetary policy, and pushing for the Fed to shrink its balance sheet, which he believes should create room for rate cuts.
However, before Walsh has even chaired his first Fed monetary policy meeting, the bond market has delivered a "rate hike gift" in advance. As persistent inflation pressures have dashed hopes for near-term rate cuts, U.S. Treasury yields have climbed rapidly in recent days. Currently, the 10-year Treasury yield has risen to 4.665%, and the 30-year yield to 5.180%. The policy-sensitive 2-year Treasury yield stands at 4.108%, above the upper limit of the Fed's benchmark rate range.
Typically, the 2-year yield does not remain consistently above the federal funds target range. This anomalous pattern means that the market has effectively completed a rate hike cycle on its own before Walsh's first policy meeting (scheduled for June 16-17). This repricing in the bond market is eroding the policy flexibility Walsh might have had.
Vincent An, a fixed-income portfolio manager at Wisdom, stated bluntly that Walsh likely hoped to have the option to cut rates on his first day, but the bond market has taken that option off the table. An characterized this as a classic operation by the "modern bond vigilantes"—instead of destroying Fed credibility with a sudden yield spike, they gradually erode its policy options by pushing the entire yield curve above the policy range.
Wall Street veteran Ed Yardeni, founder of investment advisory firm Yardeni Research, issued a concerning warning on Monday. He noted that the incoming Walsh was sent to the Fed to lower rates, but he may instead need to push for rate hikes to establish credibility. The creator of the term "bond vigilante" pointed out that if the new Fed Chair fails to signal that policymakers are focused on inflation pressures, it could trigger further market turmoil, causing Treasury yields to continue soaring.
Yardeni wrote in a note on Monday: "Walsh will chair the June FOMC meeting, but who is really in charge of monetary policy? We think it's the bond vigilantes. The bond market worries he will tolerate inflation rather than raise the federal funds rate. He will likely have to yield sooner or later and join the tightening camp. The activists in the bond market will force him to change his stance. So will his FOMC colleagues."
Furthermore, Yardeni believes the Fed's rate hikes could come faster. He expects the Fed to hold rates steady at the June meeting, while a 25-basis-point hike in July is "quite possible." He also thinks the Walsh-led Fed could take a first step toward tightening at the June meeting by removing dovish language from the "forward guidance" in the post-meeting statement, language previously interpreted as signaling the central bank's next move would be a cut.
Yardeni stated: "The Fed must keep pace with the bond market to avoid losing control of borrowing costs and to placate bond market investors. Right now, they might prefer to see the Fed tightening rather than staying neutral. An unexpected federal funds rate hike might actually make them happy!" He believes that early tightening by the Walsh-led Fed would help ease bond market concerns, suppress yields, and give the Fed greater flexibility later on. He added: "Therefore, by taking a hawkish stance, Walsh might have a chance to fulfill the White House's wish—to lower real borrowing costs. Mortgage rates could fall, corporate financing pressure would ease, and Trump could claim falling long-term yields as an economic victory."
**Just Speculation?**
Despite the bond market front-running bets on Fed hikes, a latest survey shows most economists expect no rate cuts this year and view the bond market's pricing of hikes as purely an overreaction.
The federal funds rate has been held in the 3.50%-3.75% range since last December. Now, less than half of economists polled expect the rate to be lowered within this year—a stark contrast to last month when over two-thirds expected at least one cut. Nonetheless, economists' overall assessment of the rate outlook remains relatively mild, continuing to view the inflation spike triggered by soaring energy prices since the Middle East conflict escalated two and a half months ago as temporary and unlikely to spread more broadly to other consumer prices.
Among the 101 economists surveyed between May 14 and 19, nearly 85% (83) expect the benchmark rate to remain unchanged in the 3.50%-3.75% range through the third quarter. In contrast, just over half held that view last month, and nearly 70% in March expected at least one cut by then. Regarding the year-end rate level, economists have not reached a clear consensus, but nearly half (49 out of 101) expect no changes this year, a higher proportion than the previous roughly one-third. Nearly one-third expect one rate cut this year, mostly in December. Four economists expect at least one rate hike.
Regarding the recent rapid climb in bond yields, many strategists have explicitly expressed skepticism, believing there is a clear "overreaction" at present. A core质疑 lies in the extremely thin trading volume of forward rate contracts. Will Compenolle, a macro strategist at FHN Financial, pointed out that far-month contracts have very poor liquidity. Taking the May 2026 and January 2027 contracts as examples, the former's trading volume this month is about three times that of the latter. Some contracts further out have traded only a few thousand times. "This is a low-confidence signal; the market might just be hedging against potential hike risks."
Ryan Swift, Chief U.S. Bond Strategist at BCA Research, similarly stated that financial markets digest information much faster than actual data evolves, sometimes correctly anticipating signals early, but "more often than not, it's simply an overreaction."
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