How high is the threshold for the Federal Reserve's rate hikes? ( GuoLianMinSheng Macro Lin Yan

Only a few weeks, market expectations for liquidity for the rest of this year took a sudden 180-degree turn. Under the pressure of continued tensions in the Persian Gulf and elevated international oil prices, inflation risks have flared up again. This month, major central banks have generally held steady, and some even signaled “hawkish” stances—causing the market’s prior easing expectations to reverse quickly. At present, the risk of the world returning to a tightening cycle is notably higher, and the pressure for liquidity to tighten is becoming even more pronounced. Large asset classes, with the exception of crude oil and the U.S. dollar, have generally experienced sharp pullbacks.

The same is true for the Federal Reserve. At the start of the year, markets widely expected the U.S. to cut rates about twice within the year; but with renewed concerns about inflation, policy expectations have shifted significantly. The market has even begun pricing in the possibility that it may restart rate hikes.

However, market expectations often have the inertia of linear extrapolation, so there remains a possibility of back-and-forth adjustments later on. Just like the rapidly warming rate-hike expectations in this round—once subsequent correction appears, the momentum for the market’s reverse adjustment could be extremely intense.

So, is there a possibility the Federal Reserve will hike rates again this year? We believe this probability is low. The threshold for the Federal Reserve to restart rate hikes is currently high. Under multiple constraints, the baseline is to keep rates unchanged or maintain its policy floor. And against the backdrop of weak economic performance and blocked efficiency of inflation transmission, continuing rate cuts within the year remains a plausible scenario. Specifically,

1、Learn from history: How the Federal Reserve moves into a rate-hike cycle?

First, when we review past rate-hike cycles, we can see that, based on the Fed’s dual goals of employment and inflation, the start of a rate-hike cycle in the U.S. typically has the following hallmark features:

1）Sustained improvement in the labor market and economic resilience driven by tight labor supply and demand often form an important prerequisite for the Fed to begin tightening. In the rate-hike cycles since 1970, in the three months leading up to the start of a rate hike, the U.S. average monthly increase in nonfarm payrolls has generally been maintained at around 200,000. The unemployment rate has trended downward overall, and strong employment performance has provided solid fundamentals supporting the Fed’s decision to launch monetary tightening.

2）The inflation level is an important consideration for rate hikes, but inflation expectations are equally important, and this directly determines the urgency and intensity of the Fed’s tightening policy. Rate hikes by the Federal Reserve do not always simply track a clear rebound in inflation. After the economy stabilizes, even if inflation is mild in the short term, the Fed may still take preventive rate hikes out of concern about wage stickiness and the possibility of inflation bouncing back. In this case, expectations for future inflation are even more important. Meanwhile, during the oil crises of 1973 and 1977 and major supply shocks such as the global supply chain and energy disruptions in 2022, the Fed has more often responded with a lag. The pace of rate increases tends to move in sync with, or even lag behind, the rise in prices.

By contrast, the current stage shows clear differences between the macro environment and historical rate-hike cycles:

On the one hand, the U.S. labor market has already shown a持续ly weak state, and the foundation for employment recovery is not solid. Currently, the U.S. nonfarm payrolls’ middle level remains near 0, and the unemployment rate is also trending upward. Under these circumstances, if the Fed were to start rate hikes rashly, it would not only fail to provide policy support, but could further hit the already fragile labor market and exacerbate downside pressure on the economy.

On the other hand, although there are short-term concerns about inflation, inflation expectations remain relatively stable. We believe the core reason is that in this round, the rise in international oil prices lacks the key foundation for sustained inflation transmission on both the supply and demand sides. Compared with the 1970s oil crises and the two energy price shocks caused by the Russia-Ukraine conflict in 2022, the reason those events could continue to spread toward inflation is essentially inseparable from the special supply situation and strong demand-stimulus policy support at that time. But these key conditions are not present today.

Looking more closely, the stagflation situation in the U.S. in the 1970s stemmed from a combination of supply shocks and insufficient policy resolve, which ultimately caused inflation expectations to become unanchored. In fact, even before the oil crisis, the hidden risks of U.S. inflation had already begun to show. Under the Keynesian stimulus framework the government had followed for a long time after World War II, to maintain high economic growth and full employment, the U.S. continuously implemented expansionary fiscal and monetary policies: on the one hand, the “Great Society” welfare programs greatly expanded fiscal spending, causing the U.S. deficit ratio to rise overall in the mid-to-late 1960s; on the other hand, the Fed maintained easy monetary liquidity for a long time, with the money supply growing too quickly, driving total demand to remain overheated and pushing inflation expectations higher and higher. The Fed did not tighten policy in a timely way to rein it in, and even later, its resolve to fight inflation was clearly insufficient.

Ultimately, under a series of supply shocks in the 1970s, inflation expectations became completely unanchored. After the Middle East war led to OPEC’s oil embargo, international crude oil became severely short. Because the U.S. at the time was a net importer of crude oil and highly dependent on overseas supplies, weak energy self-sufficiency meant that rising oil prices directly increased production costs across the entire U.S. industry chain. Companies were forced to raise prices, which became a core trigger for broad-based inflation. In addition, U.S. unions were relatively strong at that time, making wages easy to rise but hard to fall. This further pushed up companies’ costs and caused prices to continue rising, forming an inflation spiral.

As for the high inflation in the U.S. in 2022, it was more the result of demand overheating after the pandemic and a rebound in tension in the labor market. Of course, the Russia-Ukraine conflict, which restricted global energy supply, was an important external trigger for this inflation surge; but the more fundamental driver was the massive-scale fiscal and monetary stimulus policies introduced during the pandemic, which provided demand support for cost pressure to transmit persistently to downstream. Excess savings held by residents concentrated release boosted consumer demand temporarily and sharply; combined with a tight labor market (as labor force participation fell drastically due to the pandemic), wage growth surged. Cost pressure then rapidly transmitted across goods, services, and even into the rent market, ultimately generating broad-based high inflation not seen in nearly four decades.

The走势 of inflation structure also supports this: U.S. energy inflation in 2022 already topped and quickly fell, and it also dragged goods prices down. But core CPI components such as housing did not enter a downward path until mid-2023. The overheating of service demand under fiscal stimulus is an important reason why this round of inflation has relatively strong persistence.

At present, whether it is the ability to absorb supply shocks on the supply side, or the transmission momentum on the demand side, both have fundamental differences compared with the previous two rounds:

On the supply side, the U.S.’s role in the global energy supply landscape has changed, fundamentally weakening how much oil price increases can spread into inflation transmission. On the one hand, the shale oil revolution increased the U.S. crude oil self-sufficiency rate and made it a net exporter, significantly enhancing its ability to withstand geographic supply disruptions and making it hard to form a persistent energy gap. At the same time, crude oil export revenues can offset increases in corporate costs, to a certain extent curbing the incentive to raise prices. On the other hand, the rapid rollout of new energy and continuous improvements in industrial energy efficiency have reduced the overall economy’s reliance on crude oil. The energy component’s weight in the CPI basket has continued to decline, weakening its impact on overall inflation.

Meanwhile, the absence of a wage–inflation spiral mechanism has also become an important factor in restraining costs and preventing inflation from continuing to spread. Currently, the U.S. labor market is cooling steadily, job openings are gradually narrowing, and with the decline in union strength and wage stickiness, there has not yet been a clear positive feedback loop formed between wages and inflation. This effectively blocks the possibility of cost pressure rising in a spiral and pushing up prices broadly.

On the demand side, a weak economic pattern makes it hard for oil price increases to transmit smoothly downstream to raise prices broadly. Even though the Fed has begun a rate-cut cycle, policy interest rates are still significantly above the neutral level, meaning the overall monetary environment remains tight. This continues to suppress consumption of household durables, investment, and the real estate market. At the same time, with the U.S. government debt burden high and fiscal space clearly constrained, large-scale demand-stimulus policies have already been stepping down, and the fiscal side’s “bottoming out” support for total demand has noticeably weakened.

Under the K-shaped divergence of the U.S. economy, this round of oil price increases lacks broad demand support, making it difficult to turn into comprehensive, persistent upward price pressure from the energy side. Especially under high interest rates, core inflation components such as housing are still in a trend decline channel. This further weakens the upward momentum for overall inflation, providing crucial demand-side support for inflation expectations to remain stable.

Looking back at history, it is also not hard to see that since the large stagflation of the 1970s, the oil-price volatility’s second-round pull on core inflation has been significantly weakened. This is thanks to the transition in energy structure, the strengthening of Federal Reserve discipline, and more flexible adjustments in the labor market. Especially when demand-side strong support is lacking, oil price shocks are much less able to form sustained inflation transmission momentum.

Therefore, when faced with such supply shocks, the Federal Reserve’s traditional policy logic is usually: do not consider the short-term upswing in inflation stages; wait until inflation transmission becomes more complete and core inflation rebounds steadily, or until inflation expectations clearly rise. Only after a clear “second-round inflation” effect emerges should it consider starting rate hikes. The core is also that the continuity of short-term supply-side transmission is not yet clear, and economic slowdown often provides some offset to inflation.

Of course, this time is no exception. Whether from the weak labor market performance mentioned above or from the efficiency of inflation transmission, the U.S. this year does not have the conditions to hike rates. Moreover, short-term uncertainty remains significant in the Middle East geopolitical situation; the continuity and trajectory of international oil price increases are unclear. Combined with the inconsistency of the Trump administration’s stance on the policy level, if the Fed were to hike rates rashly, and if oil prices were to fall afterward, frequent adjustments in the Fed’s policy stance would easily exacerbate market expectation disorder and trigger large swings in financial markets, which would ultimately be unfavorable for the smooth operation of the economy.

2、The cost of rate hikes? From a “stagflation” trade to a “recession” trade

In addition to strict conditions for rate hikes, the cost of rate hikes is also something the U.S. economy and the Trump administration find hard to bear. Against the backdrop of an increasingly fragile U.S. economy and financial markets (besides AI), hasty rate hikes are highly likely to cause significant negative shocks to the economy. The “stagflation” trade priced by the market currently may have limited persistence, so the likelihood of it evolving into a “recession” trade is not low.

As we mentioned earlier, the U.S. economy’s core issue now is “K-shaped” divergence—which is also the fundamental problem Trump needs to solve in this midterm election year. On the one hand, he needs to maintain the support of AI investment for the economy, and also the boost to consumption from the stock market rally. On the other hand, he needs to sustain the力度 of fiscal expansion to “protect people’s livelihoods.” Once interest rates rise, the negative shocks to both are obviously visible:

First, regarding AI investment: although the AI industry is still in the stage of implementation and deepening, and it may not yet have reached the level of forming an asset bubble, the market has already repeatedly expressed concerns about high valuations and overly fast price increases. The overall fragility of technology stocks has risen notably, making them extremely sensitive to policy and liquidity changes—just a slight “breeze” can easily trigger large fluctuations. Once the rate hikes land, the market may form persistent negative expectations, leading to a rapid fall in risk appetite. This would not only cause valuation pullbacks in technology stocks (MAG7 accounts for more than 30% of the total market capitalization of the S&P 500), and directly reduce the wealth effect for households. More importantly, it could directly cool down investment and financing in the AI sector and shrink capital expenditures.

This logic is not unique. Historical experience from the dot-com bubble period in 2000 is highly instructive: during cycles of liquidity tightening and rising interest rates, high-valuation growth sectors are often hit first. The valuation expansion driven by earlier capital flows cannot be sustained. If earnings realization also fails to meet expectations, it easily triggers a “double whammy” of valuations and earnings (“the Davis double blow”), leading to synchronized cooling of both the capital market and industrial investment. In 2000, as the Federal Reserve kept raising rates consecutively, the valuations of dot-com leaders such as Cisco, Microsoft, and Intel collapsed quickly, and stock prices fell sharply. The market rapidly revised its growth narrative for the new economy, capital expenditures contracted significantly, and falling risk appetite and slowing industrial investment reinforced each other, forming a clear negative feedback loop.

Similarly, AI investment is crucial to growth in the U.S. economy today and has become an indispensable link. As of 2025 Q4, the contribution of AI-related investment to the U.S. economy’s annualized quarter-over-quarter growth rate reached 1.07% (4QMA), accounting for roughly about half of total growth. If rising interest rates trigger a rapid contraction in corporate investment, it could significantly amplify downside pressure on the economy and become an important driver pushing the economy toward recession.

Second, the “double squeeze” effect created by rate hikes and rising oil prices could significantly worsen living costs and debt-servicing pressure for middle- and low-income groups, and may even trigger deeper livelihood challenges. In fact, the economic situation of middle- and low-income groups in the U.S. is already relatively fragile. As we have revealed in our report, middle- and low-income groups have clearly fallen behind in economic growth, and livelihood pressure has become a core pain point for the U.S. economy.

Against this backdrop, if rising oil prices and the rate-hike cycle resonate, it would undoubtedly be “adding insult to injury.” Higher oil prices directly raise basic living expenditures such as transportation and heating, eroding disposable income that has already been shrinking. Meanwhile, rate hikes mean higher interest expenses such as mortgage payments and credit card debt, further squeezing household financial flexibility. When both effects combine, it may not only force middle- and low-income households to cut necessary consumption and delay big-ticket spending, but could also push them toward the brink of debt defaults—posing a material threat to their quality of life and balance sheets. This is very unfavorable for Trump in handling the midterm election.

According to calculations by the Dallas Fed, the closure of the Strait of Hormuz would cause a significant impact on the U.S. economy in the second quarter of 2026, with a single-quarter drag of around 2.9 percentage points. Although short-term reopening might allow economic activity to rebound and catch up, the substantive supply-chain shock has already formed. The decline in global supply-chain efficiency and subsequent inventory disruptions will inevitably weigh on both the scale and timing of economic recovery. If rate hikes were added at this time, the supply shock and tighter financial conditions could reinforce each other and potentially push the U.S. economy into severe slowdown.

Therefore, whether due to pressure from economic downside or Trump’s political considerations, the costs and obstacles that rate hikes would bring to this administration are undoubtedly large.

3、Potential “milestones” for restarting rate hikes within the year?

So, what conditions could trigger rate hikes by the Federal Reserve this year? We believe that if the Federal Reserve is to restart rate hikes this year, it may need resonance across multiple areas, such as the sources of inflation, demand transmission, and policy constraints:

On the inflation source front, the Middle East situation is showing a tendency toward long-term stalemate, keeping oil prices at 100-120 U.S. dollars or even higher throughout the year. Based on our prior estimates, under a static model, U.S. inflation would rise back to more than 3.5% this year. More importantly, if geopolitical conflicts continue to intensify and supply disruptions are difficult to ease, the continued upward movement in energy prices would ignite longer-term inflation expectations. This would be more critical for a Fed policy shift than a simple rebound in inflation readings.

On the transmission mechanism front, Trump may need to introduce even more forceful fiscal expansion policies to break through demand bottlenecks. In a midterm election year, if Trump imitates the large-scale fiscal stimulus introduced during the Biden era—by directly boosting residents’ disposable income through measures such as subsidies to residents, tax cuts, and a series of promised affordability support policies—then it could quickly activate end demand and break the chain through which oil prices transmit into downstream investment and consumption. This could become the biggest source of a second round of inflation within the year.

On policy constraints, whether Waller can uphold policy independence is also a key condition that cannot be ignored. Compared with Powell, Waller’s current policy stance is clearly more dovish. During this election campaign, the public positioning leans toward bringing interest rates down to around 3%, showing relatively weak policy resolve and less determination to fight inflation. Under pressure from the White House, the likelihood that he would pivot toward tightening is worth questioning. In addition, the transition process for the Fed leadership itself constitutes another potential risk: if Waller fails to be confirmed smoothly by the Senate, Powell would continue to preside over decision-making in an acting chairman capacity, which could increase the probability of restarting rate hikes within the year.

Therefore, combining the three conditions above, we believe the key warning indicators to focus on this year include: the marginal change in inflation expectations (the persistence of oil prices), the timing and on-the-ground effects of fiscal policy introductions, and Waller’s subsequent policy statements and decision-making inclinations. These variables will jointly affect whether the Federal Reserve shows a policy shift this year, as well as the timing and magnitude of that shift.

But at least for now, given the difficulty of meeting the conditions above, both the difficulty and the threshold for the Federal Reserve to hike rates within the year are not low.

Risk warning: U.S. inflation persistence exceeds expectations and tariff transmission exceeds expectations; geopolitical conflict escalation and a sharp rise in oil prices; U.S. fiscal policy exceeds expectations; there may be deviations in data and model estimates.

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