War ignites inflation, and Walsh faces his first challenge: how to "hold back the hawks"?

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The new Fed Chairman, Walsh, faces a stern test at the start of his term. This policy maker, who once gained trust with a clear “rate-cut roadmap,” is now confronted with an entirely opposite scenario—how to curb rising market bets on rate hikes at a time when inflation has reignited and his colleagues are turning hawkish.

According to Bloomberg, data to be released this Thursday is expected to show that the Fed’s preferred inflation gauge—the Personal Consumption Expenditures (PCE) Price Index—rose 3.8% over the past 12 months, nearly two percentage points above the 2% policy target. At the same time, energy shocks triggered by Middle East turmoil are further elevating inflation pressures, market expectations for rate cuts have faded, and investors now begin to bet on potential rate hikes.

It is noteworthy that Walsh’s situation is further complicated by political factors. Just hours after he presided over his oath-taking ceremony, Trump publicly stated that interest rates would “soon” come down, reigniting concerns about the Fed’s independence. Stephanie Roth, chief economist at Wolfe Research, remarked:

“The market no longer expects rate cuts. Walsh’s biggest challenge this year is to get the market to digest the already priced-in expectations for rate hikes.”

Inflation exceeds expectations, rate-cut window fades

Persistently rising inflation has become the key factor reversing market expectations. The Consumer Price Index for April recorded the largest single-month increase since 2023, and investors quickly shifted their bets from rate cuts to rate hikes.

Long-term inflation expectations are also under pressure. The University of Michigan’s May consumer survey shows consumers’ annualized inflation expectations for the next 5 to 10 years rose to 3.9%, up from April’s 3.5% and hitting a seven-month high.

Much of the inflation pressure comes from energy prices. Analysis suggests that even if Middle East conflict ends, energy costs are expected to remain elevated for several months. Meanwhile, massive investment in the field of artificial intelligence is also pushing up service sector costs and core inflation pressure.

Derek Tang, an economist at LH Meyer/Monetary Policy Analytics, said: “Walsh has no room left to construct arguments for rate cuts. He must focus on resisting the growing pressure from colleagues and the public for policy tightening.”

Hawkish voices gather, June meeting may be a turning point

Currently, the hawkish shift within the Fed is quite evident. In recent weeks, several officials have issued warnings, saying the central bank can no longer hint that rate cuts are still the next step, but should make clear the risks of policy tightening. This stands in sharp contrast to the stance early this year, when officials expected to continue easing until 2026.

Especially noteworthy is the shift by Fed Board Member Christopher Waller. He strongly advocated rate cuts for 2024 and 2025 but now supports signaling that the next rate move could also be a hike. Diane Swonk, chief economist at KPMG, commented: “Inflation has become sticky, and Walsh is entering a narrative shift.”

The June policy meeting may become a critical juncture. At that time, officials may delete the so-called “easing bias” language from the policy statement and submit new economic projections. The market expects that the new projections will raise inflation forecasts and postpone the timetable for future rate cuts.

Policy is already accommodative, inaction may be Walsh’s 'optimal solution'

Some economists have deeper questions about the current policy stance. Matt Luzzetti, chief U.S. economist at Deutsche Bank, warned that the Fed may have set rates too low for 2024 and 2025, making the policy environment relatively accommodative. This concern is especially prominent against the backdrop of resurging inflation—rising prices can lift the neutral rate, making the current policy more stimulative in practice.

Fabio Natalucci, CEO of Andersen Institute for Finance & Economics and former Fed and IMF official, further pointed out: “If you do nothing, you're essentially loosening policy.” Currently, most Fed officials still consider policy to be within the neutral or slightly above-neutral range.

Robert Sockin, chief U.S. economist at PGIM, explained from a more pragmatic angle that the threshold for rate hikes is higher than for rate cuts. “Even before Walsh took office, this judgment was already valid.” This means that in the current complex environment, keeping rates unchanged may be the best outcome Walsh can hope for.

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