What conditions are required for the Federal Reserve to raise interest rates?

After expectations of rate cuts were almost completely priced out by the market, investors began to turn their attention in another direction—could the Federal Reserve possibly restart rate hikes? The answer from Bank of America economists is: the threshold is very high, but not impossible.

Aditya Bhave, US economist at BofA Merrill Lynch, indicated in a research report published on March 20 that the Federal Reserve would need at least three conditions met simultaneously to raise rates: a stable labor market (unemployment rate below 4.5%), a further rise in core inflation (core PCE above 3.2%), and Jerome Powell still serving as Chair.

The report argues that these conditions are most likely to be met under a scenario of a sustained but moderate Iran shock, corresponding to an average WTI crude oil price between $80 and $100 per barrel.

In terms of market pricing, there has been significant change this month. Less than three weeks ago, the market was pricing in about 60 basis points of rate cuts for this year; now, expectations for rate cuts are nearly zero, and investors' risk assessments between hikes and cuts are becoming balanced. The BofA report notes that supply shocks themselves create bimodal risks for monetary policy, and the direction depends on whether policymakers are more concerned about inflation or employment.

Labor market is the primary prerequisite

The BofA report lists labor market stability as the primary condition for the Fed to consider rate hikes. Citing the precedent from 2022, the report notes that the Fed was able to aggressively hike rates during a technical recession because the unemployment rate remained below 4% and was falling, with monthly nonfarm payroll growth averaging close to 400,000.

The report asserts that for this round to restart rate hikes, the unemployment rate must stay below 4.5%. If conditions approach the threshold, moderate wage growth, stable initial jobless claims, and stabilization or rebound in the job vacancy rate will collectively form supportive auxiliary arguments for rate hikes.

Although the Fed has clarified that its policy targets employment rather than GDP, resilient consumer demand will provide greater room for rate hikes. BofA's internal credit and debit card aggregation data show that consumer spending—excluding oil and gas—continues to grow robustly, indicating consumers' wallets have not been significantly strained by rising oil prices.

Core inflation must break a critical threshold

Even if the labor market stabilizes, the Fed will need to see the Iran shock substantially transmitted to core inflation, not just limited to energy prices. The report states that this transmission could happen via two routes: first, rising energy prices push up input costs for core goods and services—the Fed estimates a 10% rise in WTI would contribute about 7 basis points to core inflation over a period; second, the shock evolves into a broader supply chain disruption like in 2021–2022, with climbing shipping costs and prices in natural gas, fertilizers, aluminum, etc., now raising this risk.

The report notes that core PCE inflation is currently at an unsettlingly high level; both BofA and the Fed expect the year-on-year reading for February to reach 3.0%. If core PCE monthly growth reaches 0.24% or higher for three consecutive months, driving year-on-year up to 3.2% or above, a policy shift could be triggered. However, the report warns that if inflation is clearly driven by tariffs, the Fed may choose to temporarily tolerate it, as tariff effects are expected to dissipate starting mid-year; in contrast, sustained rise in core services inflation will raise greater concerns among policymakers.

For inflation expectations, long-term inflation expectations remain fairly stable, in contrast to a slight increase after the "Liberation Day" last year. But the report points out that even if long-term expectations stay stable, the Fed may still invoke 2022’s logic to start rate hikes if short-term inflation rises significantly, as a preventive measure against expectation de-anchoring.

Chair selection shapes the policy threshold

The report lists whether Powell remains in charge at the Fed as a third necessary condition for rate hikes, and asserts that this factor’s influence on the policy threshold cannot be ignored.

BofA characterizes Powell as a moderate dove, preferring to protect the labor market when inflation and employment risks are roughly balanced. By contrast, Fed Chair nominee Warsh is expected to take an even more dovish stance, meaning that under his leadership the threshold for rate hikes will be significantly higher.

The report acknowledges that Warsh’s stance is hard to characterize simply—he demonstrated strong hawkish tendencies during his Fed Board term and the 2021–2022 inflation cycle, yet his recent public statements emphasize the urgent need for rate cuts, making it difficult for the market to judge his policy orientation if appointed.

On the timeline, BofA previously expected Warsh’s confirmation to be completed before the June meeting, but now faces delay risk. Senator Tillis has made it clear he will not move forward Warsh’s nomination in the Senate Banking Committee until Powell’s case is resolved, and he happens to be a key vote on that committee. Powell confirmed at a March press conference that if a new Chair is not yet in place by then, he will preside over the June meeting. BofA believes June is the earliest possible meeting for the Fed to start rate hikes, and whether Powell is still in post by then will directly affect this possibility.

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