Not only will there be "no rate cuts"! In these three scenarios, the Federal Reserve may even raise rates again.

``` The Fed raising rates this year is still not the baseline scenario, but it is no longer just a tail risk. The blockage of the Hormuz Strait is driving up commodity price pressures, and AI-related capital expenditures are squeezing parts of the global supply chain. The market has started to reprice a "hawkish shift": the probability of a rate hike before the December 2026 FOMC meeting has surpassed 60%, and by March 2027, a rate hike has been fully priced in. According to Chasing Wind Trading Desk, Barclays FICC economic researchers including Jonathan Millar made the core judgment in their May 18 Fed commentary: "While our baseline scenario also does not anticipate a rate hike before the end of 2027, the upside risk for the policy rate has clearly increased." The three clear triggers for a rate hike: long-term inflation expectations become unanchored; core inflation remains persistently high after tariff shocks subside; demand outpaces supply, especially if the AI investment cycle and wealth effect are unleashed before productivity improves. The baseline path remains mild: the Fed keeps rates unchanged until 2026, with the next step being a 25 basis point rate cut in March 2027. This judgment depends on two premises: the Hormuz Strait disruption ends quickly, and tariff pass-through and energy-related price pressures subside; at the same time, consumer spending slows, cooling overall demand. But the probability distribution is no longer so "dovish." Subjectively, the probability of a 25 basis point rate cut in 2027 is 35%; rates remaining unchanged until the end of 2027 is 30%; the probability of rate hikes is 25%, with an extent of about 50-100 basis points; the chance of a recession triggering sharp rate cuts is 10%. In other words, the most likely deviation is not an immediate rate hike but a delay in rate cuts. ## The market no longer sees rate hikes as a tail risk The change in the rates market is direct. Before the Iran conflict, the market was still pricing more rate cuts; afterward, pricing quickly shifted toward rate hike risk. The variables behind this are not just a single oil price shock. ISM manufacturing and services payment prices, the New York Fed's global supply chain pressure index—all point to rising cost pressures; meanwhile, the U.S. labor market has not deteriorated significantly, with unemployment remaining low and the three-month average non-farm payrolls still appearing "stable." This is tricky for the Fed. If it is merely a one-off increase in price levels, policy can "look through" it; but if the shock lasts long enough and inflation expectations, wages, corporate pricing behavior begin to follow, the issue turns from a supply shock to inflation inertia. ## The shortest path to rate hikes: long-term inflation expectations unanchored The most direct trigger is long-term inflation expectations loosening. **What needs to be watched is not one or two months of CPI, but the 5-10 year market-based inflation expectation, especially the 5y5y inflation breakeven rate.** If such indicators continue to rise, showing erratic movement and decoupling from short-term inflation changes, the Fed will see it as a sign that the credibility of the 2% inflation target is impaired. If survey-based long-term inflation expectations from the University of Michigan, New York Fed, and others rise simultaneously, this judgment will be reinforced. We are not there yet. Long-term inflation breakevens have not shown the Fed’s credibility being questioned, and survey-based long-term expectations are only somewhat elevated. The real risk is if disruptions from the Hormuz Strait and commodities last too long and are too large, the market will start to doubt whether the Fed is still willing to trade off growth and employment for the 2% goal. Should such signs emerge, policy communication will likely turn hawkish first. The Fed will not wait for all data confirmation before warning the market. ## After tariffs subside, if core PCE still doesn't come down, that's trouble The second path is slower but more realistic: core inflation repeatedly exceeding expectations. A key threshold in the framework is core PCE month-on-month around 0.18%, which aligns with a 2% target on a monthly basis. If core PCE consistently exceeds this level, while tariff-related pressures should have started to fade, the Fed's room to watch on the sidelines will shrink. Several subcomponents matter more: core goods not showing expected disinflation; non-housing core services—so-called "super core"—not cooling much; global supply chain pressures rising again; trimmed mean or median inflation indicators strengthening, showing that pressures are no longer concentrated in a few items. **The key word in this path is "persistency." One month’s data is not enough, nor necessarily a few months; but if it persists for several quarters, it becomes hard for the Fed to explain as a temporary disturbance.** Here is a fork: if inflation stays high and demand is strong, policy bias will shift toward tightening; if demand is clearly weakening but inflation is still high, the Fed’s dual mandate will conflict. But after the 2021-2022 inflation shock, the bar for not prioritizing price stability is very high. ## AI may boost demand first rather than suppressing inflation immediately The third path is less related to Middle East conflict and stems more from U.S. domestic demand. **The AI investment cycle is accelerating. Private domestic final purchasers have not notably slowed, AI-related investment has picked up again this year, and financial conditions under the Fed’s models are still growth-supportive. If AI-driven capital expenditures and equity wealth effects are unleashed before productivity and cost efficiencies arrive, the result could be demand surging first, rather than falling inflation.** This differs from the Greenspan era’s tech story. At that time, productivity gains were hard to recognize in real time, supply improvements came first, and demand responded with a lag; this time, the market is already fully expecting AI-driven productivity gains, and these are reflected in financial conditions and spending patterns. The data is mixed. Nonfarm business sector productivity rose nearly 3% in the four quarters ending Q1 2026—about twice the pre-pandemic pace; but San Francisco Fed’s utilization-adjusted metrics suggest the rate may be overestimated by about 1.5 percentage points. In other words, apparent supply improvements may not be enough to support demand that has already been released in advance. The Fed will judge any overheating from several traditional signals: growth exceeding trend, unemployment dropping below the NAIRU range of 4.0%-4.3%, wages reaccelerating, and pay gains exceeding actual productivity. There is not yet strong evidence of wage reacceleration, but this is something to keep a close eye on. ## Baseline remains a rate cut in 2027, but with picky prerequisites The baseline scenario is unchanged: standing pat for a long time, with a 25 basis point rate cut in March 2027. The logic is that by then, energy, tariffs, and supply chain–related price pressures will have faded, core PCE will have slowed significantly, and the Fed will have the room to bring policy rates closer to the long-term neutral rate. This path is highly sensitive to how long the Hormuz Strait disruption lasts. If the disruption is brief and tariff pass-through gradually fades, a rate cut window can still open; if it drags on, core inflation and inflation expectations will close that window first. Consumption is also crucial. Real disposable household income has already slowed significantly over the past year, mainly from slower employment growth; if labor supply growth continues to slow, consumption should cool as well. If this assumption fails, and AI-related capex and the wealth effect keep propping up demand, the Fed will face a tougher test: is the current policy stance tight enough? So, the Fed’s 2026 risk is not a simple flip from "rate cuts" to "rate hikes." More accurately: the rate-cut path is being squeezed at the same time by supply shocks, sticky core inflation, and AI-driven demand spillover. Rate hikes will need harder data triggers, but are back on the policy table now. ~~~~~~~~~~~~~~~~~~~~~~~~ The above excellent content comes from [Chasing Wind Trading Desk](https://mp.weixin.qq.com/s/uua05g5qk-N2J7h91pyqxQ). For more in-depth analysis, including real-time interpretation and frontline research, please join [Chasing Wind Trading Desk·Annual Membership](https://wallstreetcn.com/shop/item/1000309)  Risk Reminder and Disclaimer The market has risks, investment needs caution. This article does not constitute personal investment advice and has not taken into account the specific investment objectives, financial status, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article are suitable for their particular circumstances. Investing accordingly is at your own risk. ```