The Fed Could Raise Interest Rates if These Conditions Are Met

The surprising resilience of the U.S. job market, coupled with persistent inflation, has prompted some economists to entertain the once-unthinkable prospect of an interest rate hike by the Federal Reserve in 2025. While the notion remains controversial, it underscores the shifting dynamics of economic conditions and the central bank's response.

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Aditya Bhave, a senior economist at BofA Global Research, was among the first Wall Street experts to suggest the possibility of a hike, stating, “We now think the Fed’s cutting cycle is over. The risks for the next move are skewed toward a hike.”

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However, the majority of economists are not yet prepared to embrace this view. Ryan Sweet, chief U.S. economist at Oxford Economics, characterized the current outlook as “a very long and potentially uncomfortable pause,” arguing that a hike remains unlikely.

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Earlier consensus among economists and traders anticipated multiple rate cuts in 2025. Yet, activity in derivatives markets now indicates expectations of slightly more than one rate cut for the year. Economists at Goldman Sachs and JPMorgan forecast the Fed remaining on hold until mid-year, with the central bank itself projecting two cuts for 2025.

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While the likelihood of a hike remains slim, Gregory Daco, chief economist at EY-Parthenon, noted that the probability is no longer negligible. This shift has sparked a broader discussion on what conditions might prompt the Federal Reserve to consider raising rates.

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Many economists, including Bhave, believe a rate hike could materialize if core inflation, measured by the personal consumption expenditures (PCE) price index, were to rise above 3%. The PCE index is the Fed’s preferred inflation gauge, particularly its core rate, which excludes volatile categories like food and energy.

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In November, the core PCE inflation rate stood at an annualized 2.8%, marking nearly a year below the 3% threshold. Bhave predicted that core PCE inflation might dip to around 2.5% in the early months of 2025 as robust 2024 data cycles out. Any subsequent increase back toward 3% would be noteworthy. “Going from there to 3% would represent a pretty sizable shock,” Bhave remarked.

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Sal Guatieri, senior economist at BMO Capital Markets, concurred that a 3% inflation rate could catch the Fed’s attention but emphasized that a stronger labor market would also be necessary for a hike to occur. “We’re a long way from that,” Guatieri added.

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Inflation expectations could also play a pivotal role. Bhave suggested that a significant rise in consumer expectations for future inflation might push the Fed toward action. Recent data from the University of Michigan revealed a rise in long-term inflation expectations to 3.3% in January, the highest level since 2008.

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Oscar Munoz, chief U.S. macro strategist at TD Securities, highlighted consumer concerns over uncertainties tied to policies such as import tariffs. “People are not concerned about inflation right now but more about what’s going to happen in the future. That’s where tariff uncertainty comes in,” Munoz explained.

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Adam Posen, president of the Peterson Institute for International Economics, also weighed in, predicting that inflationary pressures stemming from proposed tax cuts, tariffs, and immigration policies could force the Fed to hike rates by mid-2025. He emphasized that the fiscal deficit implications of tax cuts could ignite further inflation. “I expect them to be tightening once the budget goes through this summer,” Posen said in a Bloomberg TV interview.

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However, not all voices align with the prospect of rate hikes. Chicago Fed President Austan Goolsbee expressed optimism about eventual rate cuts but cautioned that rising market-based measures of inflation expectations would be a concern.

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Jeffrey Cleveland, chief economist at Payden & Rygel, offered a more balanced view, describing the current economic environment as “the best of both worlds” with robust employment and easing inflation. Cleveland argued that rate hikes were unnecessary, as the Fed would not want to tighten financial conditions to the extent that it jeopardizes the labor market.

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Still, Bhave countered that the economy appears resilient even at relatively high interest rates. “We’re not talking about 200 basis points of hikes. It could be back to a rate of 5.5%. Maybe that doesn’t crush the labor market,” he suggested.

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The Federal Reserve remains committed to achieving its 2% inflation target without undermining the labor market. As the economy navigates a complex mix of strong employment data and inflationary pressures, the path forward for monetary policy remains fraught with uncertainty.

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