Investors expecting a US interest rate rise could be in for a surprise

The global energy shock triggered by the war in Iran has changed the calculus for central banks. The surge in oil and gas prices has driven up inflation. According to JPMorgan, the average headline inflation rate in developed economies increased from 2.2 per cent in January to 3.3 per cent in April. Bond markets are concerned that central banks in advanced and emerging economies have fallen behind the curve. In a report on June 5, Bank of America said 46 of 68 central banks are currently overshooting their inflation target. A growing number of central banks, particularly in Asia, have already raised borrowing costs or are signalling a tightening in policy, partly because of risks to financial stability that have been amplified by the energy crisis. Indonesia’s central bank has increased interest rates by three-quarters of a percentage point in less than two months in response to the sharp fall in the rupiah. India is under pressure to follow suit. The four major central banks – the US Federal Reserve, the European Central Bank (ECB), the Bank of Japan (BOJ) and the Bank of England – have been more cautious so far. This is about to change. The ECB is widely expected to raise rates this month despite the precarious state of the euro-zone’s economy. The BOJ is also likely to increase borrowing costs when it meets on June 15-16 amid persistent yen weakness. However, it is the outlook for US monetary policy that is far more consequential. Since May 22, the world’s most influential central bank has been headed by Kevin Warsh, whose dovish views convinced US President Donald Trump to appoint him Fed chair. Although Warsh was a long-time inflation hawk, he called for lower borrowing costs mainly to help him win the nomination. He also wants the Fed to shrink its balance sheet and believes interest rate decisions should be based on a wider range of inflation data. However, since Trump nominated Warsh in January, the financial, economic and geopolitical landscape has changed dramatically. Before the war in Iran erupted, investors expected the Fed to keep reducing interest rates this year. By the end of last week, traders were pricing in a rise of a quarter of a percentage point. Several factors have strengthened the case for tighter policy. First, the surge in energy prices has pushed up headline inflation to 4.2 per cent, a three-year high. More worryingly, some measures of inflation that exclude energy costs are also rising, adding to mounting concerns about affordability. Second, the US labour market is proving more resilient than anticipated. Having been anaemic in 2025, employment growth has picked up sharply this year. Last month, employers added 172,000 workers, almost double the number forecast by analysts. Average payroll growth in the past three months has risen to nearly 190,000 jobs per month. Third, the boom in artificial intelligence (AI) is fanning inflation. Warsh has criticised the Fed for paying insufficient attention to AI-driven productivity gains which, he believes, act as a disinflationary force. However, the immediate impact of the technology has been a surge in demand for capital and a steep rise in the price of semiconductors and the products that rely on them. In a report on June 6, Citadel Securities said “strong AI-driven investment, energy market tightness, improving labour market conditions and infrastructure bottlenecks suggest upside risks to nominal growth and inflation. The next move from the Fed is most likely a hike … perhaps soon.” Not so fast. The longer energy supply disruptions persist, the bigger the threat to growth. The resumption of hostilities between the United States, Israel and Iran makes it highly unlikely that the Strait of Hormuz will reopen any time soon. While the case for raising US interest rates is much stronger, the argument for keeping them on hold is just as compelling, and perhaps more so. In a report on June 8, UBS said “bond markets are currently too focused on the short-term inflationary impact of higher energy prices, and not enough on the potential medium-term negative economic growth impact”. Real wages fell last month for the second straight month while the savings rate has dropped to a four-year low, underscoring the sharp deterioration in consumer sentiment this year. Moreover, the increase in bond yields is doing some of the tightening for the Fed by pushing up the cost of mortgages and corporate loans. The 10-year US Treasury yield has risen from 4 per cent in early March to 4.5 per cent, while its 30-year equivalent stands at its highest level since 2007. Another key factor is concerns over the independence of America’s central bank. Trump’s persistent calls for lower interest rates, and the perception on the part of many economists that Warsh is beholden to Trump, add another layer of uncertainty to the Fed’s monetary policy decisions, particularly bond markets’ interpretation. While Warsh’s new-found dovishness has become a bigger worry for investors since the energy crisis erupted, deeper rifts within the Fed over policy – which Trump would doubtless exploit – would be more damaging to bond markets. “There are scenarios where Fed independence concerns re-emerge even if Warsh does not pursue rate cuts,” Standard Chartered said in a report. This is why the Fed is more likely to keep borrowing costs on hold this year barring a much sharper rise in inflation. Even Trump would privately view such an outcome as acceptable.

Investors expecting a US interest rate rise could be in for a surprise

.css-1c6uqr6{color:inherit;font-weight:inherit;font-size:inherit;font-family:inherit;line-height:inherit;overflow-wrap:break-word;}Rising bond yields are doing some of the Fed’s work, as are investor fears over the US central bank’s independence under Kevin Warsh

Rising bond yields are doing some of the Fed’s work, as are investor fears over the US central bank’s independence under Kevin Warsh