Following the near-total erosion of market expectations for interest rate cuts, investors are shifting their focus to another possibility—whether the Federal Reserve might restart its rate-hiking cycle. Economists at Bank of America suggest that while the threshold for such a move is exceptionally high, it is not entirely out of the question.
In a research report dated March 20, Aditya Bhave, a US economist at Bank of America, indicated that at least three conditions would need to be met simultaneously for the Fed to consider raising rates: a stable labor market with the unemployment rate below 4.5%, a further acceleration in core inflation with the core PCE index exceeding 3.2%, and Jerome Powell remaining in his position as Fed Chair.
The report suggests that these conditions are most likely to align under a scenario where disruptions stemming from Iran persist but remain moderate, corresponding to WTI crude oil prices averaging between $80 and $100 per barrel.
Market pricing has shifted dramatically within the month. Just under three weeks ago, markets were pricing in approximately 60 basis points of rate cuts for the year. Now, expectations for cuts have nearly vanished, and investor assessments of the risks between rate hikes and cuts have become more balanced. The Bank of America report notes that supply shocks inherently create a bimodal risk for monetary policy, with the ultimate policy direction depending on whether policymakers are more concerned about inflation or employment.
A stable labor market is identified as the primary prerequisite for the Fed to contemplate rate hikes. Citing the precedent from 2022, the report highlights that the Fed was able to aggressively raise rates even during a technical recession because the unemployment rate was below 4% and trending downward, with non-farm payrolls averaging nearly 400,000 new jobs per month.
Should the Fed consider restarting rate hikes in the current cycle, the unemployment rate would need to remain below 4.5%. If conditions are near this threshold, supportive arguments for hiking could include modest wage growth, stable initial jobless claims figures, and a stabilization or increase in the job openings rate.
Although the Fed has explicitly stated that its policy decisions are anchored to employment data rather than GDP, resilient consumer demand would provide more room for potential rate increases. Aggregated credit and debit card data from Bank of America indicates that consumer spending, excluding gasoline, remains robust, suggesting that household budgets have not yet been significantly pressured by rising oil prices.
Even with labor market stability, the Fed would need to see evidence that disruptions related to Iran have substantially fed through into core inflation, rather than being confined solely to energy prices. The report outlines two potential transmission channels: first, higher energy costs increasing input costs for core goods and services—Fed estimates suggest a 10% rise in WTI prices could add approximately 7 basis points to core inflation over time; second, the risk of the shock evolving into broader supply chain disruptions similar to those seen in 2021-2022, a risk heightened by concurrent increases in shipping costs and prices for commodities like natural gas, fertilizers, and aluminum.
Core PCE inflation is already at an uncomfortably high level, with both Bank of America and the Fed forecasting the February year-over-year reading to reach 3.0%. Should the core PCE index post month-over-month increases of 0.24% or higher for three consecutive months, pushing the annual rate to 3.2% or above, a policy shift could be triggered. However, the report also cautions that if the inflation surge is primarily driven by tariffs, the Fed might choose to tolerate it temporarily, as tariff effects are expected to begin diminishing around mid-year. In contrast, persistent increases in core services inflation would likely cause greater concern among policymakers.
Regarding inflation expectations, long-term expectations currently remain fairly stable, contrasting with the slight uptick observed after last year's Independence Day. Nevertheless, the report notes that even if long-term expectations remain anchored, the Fed could still invoke the logic of 2022 and initiate rate hikes to prevent expectations from becoming unanchored, provided near-term inflation increases are sufficiently pronounced.
The report identifies Jerome Powell's continued tenure as Fed Chair as the third necessary condition for rate hikes, emphasizing that this factor significantly influences the policy threshold.
Bank of America characterizes Powell as a moderate dove who tends to prioritize protecting the labor market when risks to inflation and employment are roughly balanced. In comparison, a potential nominee for Fed Chair, Warsh, is expected to adopt a more dovish stance, implying that the threshold for hiking rates would be significantly higher under his leadership.
The report acknowledges the difficulty in simply categorizing Warsh's stance—he demonstrated strong hawkish tendencies during his tenure as a Fed Governor and throughout the 2021-2022 inflation cycle, yet his recent public comments have emphasized the urgent need for rate cuts, making it challenging for markets to gauge his potential policy orientation if appointed.
Regarding the timeline, Bank of America previously anticipated that Warsh's confirmation could be completed before the June FOMC meeting, but this schedule now faces potential delays. Senator Tillis has stated explicitly that he will not advance the Warsh nomination in the Senate Banking Committee until matters related to Chair Powell are resolved, and his vote is considered crucial within the committee. Powell himself confirmed during his March press conference that he would chair the June meeting if a new Chair is not yet in place. Bank of America views the June meeting as the earliest potential window for the Fed to initiate rate hikes, and whether Powell remains in charge at that time will directly impact this possibility.