A Federal Reserve rate hike is no longer a remote possibility, with markets now pricing in a more than 60 percent chance of a tightening by the end of 2026 as persistent inflation pressures challenge the central bank’s outlook. The shift in expectations, detailed in a May 18 note from Barclays economists, outlines three distinct paths that could force the Fed’s hand, even as new Chair Kevin Warsh prepares for his first meeting.
"While our base case does not forecast a rate hike before the end of 2027, the risks to the policy rate have become more skewed to the upside," said Jonathan Millar of Barclays' FICC economic research team. "The market is beginning to recognize that any resolution to the conflict in the Middle East will take longer than desired, and the inflationary impacts expected to be transitory will likely be far more persistent."
The repricing has been swift. The CME FedWatch Tool shows the probability of a quarter-point hike in December has climbed to nearly 50 percent, with the odds of a hike by January 2027 rising to 58 percent. This follows continued disruptions in the Strait of Hormuz that have elevated energy costs and strong U.S. job growth through April.
The analysis from Barclays presents a hawkish turn for a market that had, until recently, been focused on the timing of rate cuts. The primary risk, they note, would be a de-anchoring of long-term inflation expectations. Should market-based measures like the 5-year, 5-year forward inflation expectation rate show sustained, chaotic increases, it would signal a loss of faith in the Fed's 2 percent target, compelling a policy response to reassert credibility.
A second, more gradual path to a rate hike involves core inflation remaining stubbornly high. Economists are watching to see if the core Personal Consumption Expenditures (PCE) price index, the Fed's preferred inflation gauge, continues to print above the 0.18 percent monthly pace consistent with its annual target, even after temporary tariff-related pressures are expected to fade. Persistent strength in "supercore" inflation—services excluding housing—would be a particularly troubling sign for policymakers.
The third scenario stems not from traditional inflation drivers, but from the modern economy itself: an artificial intelligence investment boom. If the capital expenditures and wealth effects from the AI boom stimulate demand faster than AI can deliver productivity gains and cost efficiencies, it could create a demand-pull inflation scenario. While nonfarm productivity has risen, some economists worry the gains are not enough to offset the pre-emptive surge in spending and investment.
This complex economic picture provides the backdrop for Kevin Warsh’s first meeting as Federal Reserve Chair in June. Nominated by President Donald Trump, Warsh has previously suggested a willingness to look through temporary price shocks and has pointed to AI-driven productivity as a potential disinflationary force.
"In theory, that framework leans dovish," Christian Floro, a market strategist at Principal Asset Management, noted. "In practice, sticky inflation alongside a strong economy may limit his ability to convince his fellow committee members."
Ultimately, Warsh holds only one of 12 votes on the rate-setting committee. While the bar for a hike remains high, the groundwork is being laid. Should inflation data continue to surprise to the upside and demand fail to cool, the conversation inside the Fed may shift from when to cut, to whether they must hike again.
This article is for informational purposes only and does not constitute investment advice.
